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Corporation  Finance 

A  TEXTBOOK  FOR   COLLEGES  AND   SCHOOLS 
OF  BUSINESS  ADMINISTRATION 


By 

ARTHUR  STONE  DEWING,  Ph.D. 

Associate  Professor  of  Finance,  Harvard 

University;   author  of  "  The  Financial 

PoHcy  of  Corpoiations  " 


Assisted  by 
FRANCES  R.  DEWING,  Ph.D. 


THE  RONALD  PRESS  COMPANY 

NEW  YORK 


Copyright,  1922,  by 
The  Ronald  Press  Company 


All  Rights  Reserved 
4 


PREFACE 

Teachers  of  economics  and  corporation  finance  have  ex- 
pressed a  wish  to  have  a  book  covering  the  leading  features  of 
corporation  finance  available  for  classroom  instruction — a  book 
that  can  be  read  easily  by  students  during  a  single  semester. 

A  clear  purpose  and  method  must  be  in  mind  in  the  prep- 
aration and  use  of  a  textbook  in  one  of  the  social  sciences. 
Sound  pedagogy  requires  that  tendencies  and  expedients  be 
reduced  to  the  form  of  definite  generalizations  devoid  of  limi- 
tations and  exceptions.  In  actual  practice  the  limitations  and 
exceptions  are  glaringly  evident ;  but  to  notice  them,  even  in 
passing,  would  confuse  the  pupil  and  create  in  his  mind  the 
impression  that  the  whole  subject  is  a  mass  of  unrelated  and 
unorganized  cases.  The  present  work,  accordingly,  is  to  be 
regarded  as  a  summary  of  the  commonly  accepted  work- 
ing principles  of  corporation  finance,  without  the  inclusion 
of  either  much  concrete  illustration  on  the  one  hand  or  ex- 
ceptions on  the  other.  It  is  suggested  that  teachers,  by  lectures 
or  supplementary  reading,  and  by  specific  problems  supply  the 
necessary  illustrations.  These  should  be  chosen  from  cases 
familiar  to  the  student  so  that  the  whole  subject  may  be  given 
a  reality  and  a  vitality  that  cannot  be  obtained  from  the  printed 
page  alone.  Teachers  will  find  it  profitable  to  make  liberal 
use  of  the  problems  to  be  found  at  the  end  of  the  book.  The 
case  method  of  teaching  the  social  sciences  has  passed  beyond 
the  experimental  stage. 

Perhaps  this  study  may  be  of  service  also  to  the 
general  reader.  We  are  living  in  the  day  and  generation  of 
the  corporation.  The  ease  of  communication  has  revolution- 
ized the  methods  of  the  conduct  of  business — and  interwoven 
in  these  changes  is  the  corporation  both  as  cause  and  effect. 

iii 


iv  PREFACE 

It  has  a  basis  in  our  general  theory  of  economics  and  in 
practical  business.  But  these  are  not  divorced  and  separate. 
In  the  preface  to  the  author's  larger  work,  "The  Financial 
Policy  of  Corporations,"  on  which  this  book  is  based,  it  has 
been  pointed  out  that  there  is  no  opposition  between  the 
theory  and  the  practice  of  sound  finance.  As  in  all  other 
phases  of  social  activity  good  practice  is  based  on  sound  theory 
and  sound  theory  has  its  constant  pragmatic  justification  in 
-successful  practice. 

Arthur  S.  Dewing 
Cambridge,  Massachusetts, 
June  12,  1922, 


CONTENTS 


CHAPTER  PAGE 

I.     The  Corporation  and  Its  Financial  Structure      .  i 

II.     Common   Stock        7 

III.  Bonds i8 

IV.  Preferred    Stocks       34 

V.     The  Promoter  and  Banker 44 

VI.     The  Promotion  of  New  Enterprises 51 

VII.     The  Promotion  of  New  Companies  in  Established 

Fields 62 

VIII.     Railroads  and  Construction  Companies    ....  76 

IX.     The  Promotion  of  Public  Utilities 90 

X.     The  Underwriting  Syndicate no 

XI.     The  Importance  of  Accounting 122 

XII.     Repairs,  Depreciation,  and  Obsolescence  ....  129 

XIII.  Payments  on  Account  of  Borrowed  Capital     .     .  138 

XIV.  The  Corporate  Surplus 150 

XV.     Insurance  and  Special  Reserves 157 

XVI.     Stockholders'  Surplus 167 

XVII.     Business   Expansion   and  the  Law  of   Balanced 

Returns 186 

XVIII.     Expansion  Among  Big  and  Little  Manufacturing 

Concerns 200 

XIX.     Railroad  Expansion 221 

XX.     The  Public  Utility  Holding  Company     ....  239 

XXI.     The  Community  of  Interests 247 

XXII.     Financing  of  Extensions  from  the  Public    .     .     .  264 

XXIII.     New  Capital  from  Sales  of  Stock — Particularly 

to   Stockholders 277 

XXIV.     Corporate   Failure 288 

V 


VI 


CONTENTS 


CHAPTER  PAGE 

XXV.     Reorganization  Methods 299 

XXVI.     Railroad  Reorganizations 313 

XXVII.     The  Reorganization  of  Industrials 330 

Appendix — Problems 347 


Corporation  Finance 


CHAPTER   I 

THE  CORPORATION  AND  ITS  FINANCIAL 
STRUCTURE 

Origin  and  Development. — Historically  the  corporation 
began  centuries  ago  under  Roman  law.  Yet  the  modern  busi- 
ness corporation  is  so  much  more  complicated  in  its  structure 
and  so  much  further  developed  that  it  may  well  be  considered 
one  of  the  inventions  of  modern  times.  It  owes  its  develop- 
ment to  the  necessity  of  organizing  capital  and  management 
ability  so  as  to  exploit  the  physical  changes  in  industry  result- 
ing from  the  use  of  steam  and  machinery. 

Simple  Financial  Structures. — From  the  point  of  view 
of  financial  structure,  there  are  a  great  variety  of  business 
corporations.  Simplest  of  all,  there  is  the  corporation  with 
the  ownership  of  its  property  divided  into  a  certain  number  of 
equal  parts.  These  parts  are  called  "shares,"  and  each  share 
is  given  a  nominal  value,  the  sum  total  of  which  should  cor- 
respond to  the  entire  property  values  of  the  corporation  at  the 
time  of  its  organization.  This  nominal  value  is  called  the 
"par  value,"  and  the  sum  total  of  the  par  value  of  all  the 
shares  is  called  the  "capitalization"  of  the  corporation. 

The  financial  plan  of  the  Walter  Baker  Company  is  a 
good  illustration  of  this  simple  plan  of  organization.  The 
owners  and  managers  of  this  corporation  created  89,000  shares 
of  units  of  equal  ownership.     Some  persons  hold  only  one 


2  CORPORATION  FINANCE  [I 

of  the  "ownerships"  or  shares,  others  hold  many;  but  altogether 
and  in  the  aggregate  they  represent  the  ownership  of  the  entire 
property  of  the  chocolate  factory,  the  good-will  of  the  com- 
pany, its  trade-marks  and  trade-names — in  fact,  all  that  it 
possesses.  The  company  has  no  debts,  other  than  its  day-to- 
day debts  for  cocoa  beans,  sugar,  labor,  and  similar  items,  so 
that  there  are  no  creditors  who  have  any  claims  to  the  property. 
In  brief,  the  entire  property  of  the  corporation  is  owned  by 
its  shareholders  in  proportion  to  the  number  of  shares  held 
by  each. 

Somewhat  more  intricate  and  yet  simple,  compared  with 
the  financial  plans  of  the  majority  of  our  large  corporate 
enterprises,  are  the  capitalization  figures  of  the  American 
Sugar  Refining  Company.  It  has  outstanding  1,800,000  shares 
of  stock,  all  considered  to  have  a  par  value  of  $100  each. 
But  of  these  shares  one-half,  or  900,000,  were  sold  to  the 
public  with  the  express  understanding  that  the  company  would 
pay  dividends  on  them  at  the  rate  of  $7  a  year  before  anything 
should  be  paid  on  the  other  900,000  shares.  Such  a  division 
of  the  capital  stock  into  preferred  shares  and  common  shares 
is  very  common  among  corporations  that  have  come  into 
existence  within  the  last  fifty  years,  but  is  rare  among  the  old 
English  and  American  corporations. 

Intricate  Financial  Structures. — A  step  further  in  the  in- 
tricate financial  structures  of  American  corporations  is  shown 
by  the  various  issues  of  stocks  and  bonds  of  the  Ameri- 
can Agricultural  Chemical  Company — the  fertilizer  "trust." 
It  has  333,221  shares  of  common  stock  and  284,552  shares  of 
preferred  stock  entitled  to  prior  dividends  of  $6  each  per  year. 
But  besides  this  share  capital  the  company  has  three  issues  of 
bonds  outstanding  representing  three  different  grades,  that  is, 
three  different  claims  to  the  property  and  the  earnings  of  the 
corporation.     There  is  an  issue  of  $6,616,000  first  mortgage 


I  ]       FINANCIAL  STRUCTURE  OF  CORPORATION        3 

bonds  which  have  a  first  or  prior  claim  to  the  property  of  the 
company,  the  interest  on  which  must  be  paid  in  preference 
to  the  interest  on  any  other  bonds  and  before  any  profits 
are  divided  among  the  stockholders.  Following  this,  there 
is  an  issue  of  $30,000,000  second  mortgage  bonds,  and  finally 
an  issue  of  $5,000,000  notes  originally  issued  for  ten  years. 
In  all,  therefore,  there  are  five  different  gradations  or  strata 
in  the  financial  plan  of  the  American  Agricultural  Chemical 
Company — three  of  bonds  and  two  of  stocks. 

On  the  whole,  probably,  the  most  intricate  financial  plans 
are  to  be  found  among  the  great  trunk  line  railroad  corpora- 
tions. The  great  variety  of  stocks  and  bonds  embraced  in 
the  New  York  Central  system  is  a  case  in  point.  Besides 
the  stock  and  no  less  than  60  separate  issues  of  bonds  of  the 
main  or  parent  corporation,  there  are  over  20  subordinate  cor- 
porations, all  of  the  stock  or  at  least  a  majority  of  the  stock  of 
which  is  owned  by  the  main  railroad  corporations.  These  sub- 
ordinate corporations  have  many  bond  issues  representing 
many  different  liens  on  the  separate  parts  of  the  system  and 
the  claims  to  the  earnings  of  these  parts.  The  intricate  inter- 
relation of  all  these  parts  presents  a  highly  complex  situation. 
It  is,  in  fact,  a  kind  of  corporation  puzzle. 

Personal  Liability  of  Partners. — The  origin  of  the  modern 
business  corporation  held  the  germ  of  all  these  later  intricate 
developments.  The  part-ownership,  which  in  the  earlier  days 
of  smaller  financial  operations  sowed  the  seeds,  involved  all 
concerned,  even  the  silent  partners,  in  the  full  risks  of  the  enter- 
prise. Such  risks,  however,  men  are  not  willing  to  assume  ex- 
cept when  they  have  such  personal  knowledge  or  associations 
that  their  confidence  in  the  managing  partners  is  very  great. 
Should  the  enterprise  meet  with  disaster,  all  who  owned  it 
would  be  responsible  for  its  debts,  even  to  the  measure  of  all 
they  possessed.     When  the  development  of  the  material   in- 


4  CORPORATION  FINANCE  [I 

ventlon  of  the  century  called  for  large  enterprises,  these  needed 
more  capital  than  any  group  of  men  could  get  together  on  such 
a  purely  personal  basis.  The  idea  of  the  modern  business 
corporation  developed  in  order  to  avoid  the  personal  liability 
involved  in  all  partnership. 

Nature  of  the  Corporation — Limited  Liability. — A  modern 
corporation  is  a  certain  definite  amount  of  capital  and  capital 
assets,  managed  according  to  a  defined  scheme  for  the  selection 
of  officers  and  the  distribution  of  profits.  It  can  enter  into 
contracts,  sue,  and  be  sued.  The  other  personal  property  of 
the  officers  and  the  profit-receivers,  the  stockholders,  is,  except 
in  case  of  fraud,  entirely  safeguarded  against  any  claims 
from  creditors  of  the  corporation  beyond  the  very  exact  state- 
ments of  the  limits  of  these  claims  given  in  what  is  called  the 
"articles  of  incorporation."  A  multiform  diversity  in  the 
articles  of  incorporation  has  developed  out  of  this  original 
idea  of  limited  liability. 

We  cannot  say  that  a  corporation  is  the  group  of  its 
owners,  for  it  has  an  existence  apart  from  them.  As  certain 
of  the  older  corporations  have  developed  working  organiza- 
tions, society  has  come  to  feel,  too,  a  kind  of  individualizing 
quality  about  them  which  is  independent  of  the  particular  men 
in  control,  although  it  expresses,  as  a  kind  of  composite  picture, 
the  financial  policy  of  the  officers  past  and  present  who  have 
developed  it.  "Standard  Oil"  means  one  kind  of  business 
policy  today;  "United  States  Steel"  means  another.  The 
closest  analogy  is  found  in  the  traditions  holding  on  from 
generation  to  generation  in  colleges,  themselves  corporations 
of  another  sort. 

Corporate  Management. — There  is  not  much  variation  in 
the  form  of  management  except  on  the  question  of  who 
elects  the  officers.      A  board   of   directors   chosen    from   the 


Ij  FINANCIAL  STRUCTURE  OF  CORPORATION  5 

Stockholders,  who  are  theoretically  the  people  interested  in  the 
success  of  the  company,  makes  all  important  appointments  and 
decisions  as  to  policy.  Most  of  these  serve  without  further  pay 
than  a  slight  fee  for  their  time  on  days  of  board  meetings. 
Some  one  or  two  among  them,  probably  a  president  and  treas- 
urer, take  detailed  charge  of  running  the  affairs  of  the  company 
and  receive  adequate  salaries.  The  other  managers  are  salaried 
officials  chosen  by  the  directors. 

Wide  Distribution  of  Investments. — With  the  definitions 
of  liabilities  and  rights  accruing  to  different  kinds  of  securities 
clearly  before  them,  the  public  at  large  has  been  able  to  make 
a  choice  of  investments  for  its  savings  on  an  impersonal  basis, 
from  published  reports  and  bankers'  estimates  of  the  promise 
of  different  concerns.  This  means  a  wider  range  of  possibili- 
ties for  investments  for  any  one  person.  Corporations  have 
further  encouraged  a  wide  distribution  of  investments  by 
selling  securities  in  small  amounts.  Even  bonds,  railroad,  and 
industrial  as  well  as  government  bonds,  originally  of  at  least 
$i,ooo  par  value  are  now  divided  into  $ioo  and  $50  units. 
As  a  result,  corporation  officials  look  to  the  great  mass  of 
people  with  small  savings  to  invest,  more  than  to  millionaires, 
to  supply  the  backbone  of  capital.  The  wide  distribution  of 
securities  has  led  to  a  wide  distribution  of  ownership  which 
makes  the  conduct  and  welfare  of  many  of  the  larger  well- 
known  corporations,  such  as  United  States  Steel,  American 
Telephone  and  Telegraph,  the  Pennsylvania  and  the  New 
York  Central  railroads,  matters  of  public  concern.  This  public 
stockholders'  interest  is  c[uite  independent  of  the  enormous 
significance  of  these  great  corporations  in  the  industrial  life 
of  the  country.  Even  before  the  present  widespread  demand 
for  the  general  publicity  of  the  accounts  and  of  the  business 
policy  of  corporations,  some  companies,  such  as  the  New 
England  cotton  mills  and  United  States  Steel  Company,  saw 


6  CORPORATION  FINANCE  [1 

the  advantages  of  taking  the  pubhc  into  their  confidence  as  a 
kind  of  advertisement  of  their  securities. 

Scope  of  Corporation  Finance. — Corporation  finance  deals 
with  the  financial  problems  of  corporate  enterprises — particu- 
larly those  of  sufficient  size  and  importance  to  solicit  public 
investment  in  their  securities.  It  deals  with  the  financial  aspects 
of  the  promotion  of  new  enterprises  and  with  the  administra- 
tion of  them  during  the  period  of  infancy.  It  deals  with  various 
accounting  problems  connected  with  the  distinction  between 
capital  and  income  and  the  various  administration  questions 
of  policy  growing  out  of  a  developing  and  expanding  business. 
Again  it  is  concerned  with  corporate  failure — the  financial 
adjustments  resulting  from  bolstering  up  or  even  rehabilitat- 
ing a  bankrupt  enterprise.  These  and  similar  topics  will  be 
discussed  in  the  succeeding  chapters. 


CHAPTER  II 

COMMON  STOCK 

Appeal  to  Investment  Motives. — The  necessity  which  led 
to  the  invention  of  the  corporation  as  a  legal  and  business 
entity  with  a  life  independent  of  its  owners  led  also  to  the 
development  of  its  more  complicated  forms.  The  most  press- 
ing problem  for  the  management  of  any  corporation  is  again 
and  again  the  problem  of  obtaining  such  capital  as  it  needs 
for  an  efficient  plant  and  efficient  methods  of  conducting  the 
business.  This  usually  resolves  itself  into  the  question  of 
persuading  the  outside  investor  to  entrust  his  savings  to  the 
care  and  management  of  the  corporation  directors;  in  techni- 
cal words,  it  is  the  question  of  making  an  investment  in  the 
securities  of  the  company  attractive.  Two  motives  are  present 
in  each  investor's  mind — the  desire  for  assured  yearly  return, 
and  the  desire  to  preserve  the  safety  of  the  principal.  The  great 
varieties  of  different  types  of  preferred  stocks  and  bonds  are 
the  outcome  of  attempts  to  appeal  first  to  one  and  then  to 
another  of  the  motives,  or  of  attempts  to  appeal  to  both  at 
once. 

Early  Use  of  Common  and  Preferred  Stocks. — In  the 
historical  development  of  the  complicated  corporation  struc- 
ture, stock  giving  direct  claim  on  actual  property  came  earliest. 
The  first  sections  of  the  early  railroads  of  the  Atlantic  sea- 
board were  built  entirely  by  stock  subscription,  just  as  the 
New  England  cotton  mills  are  now  built.  This  custom 
prevailed  down  to  1840.  However,  it  was  often  found  that 
more  money  was  required  to  finish  and  extend  the  early  sec- 
tions of  the  road  than  had  been  anticipated,  and  the  stock- 

7 


8  CORPORATION  FINANCE  III 

holders,  not  wishing  to  increase  their  subscriptions,  consented 
to  the  use  of  the  railroad  already  built  as  a  basis  for  loans. 
As  a  result  bonds  were  issued — sometimes  secured  by  a 
mortgage  and  sometimes  without  any  specific  security. 

The  use  of  preferred  stocks  rather  than  bonds  rose  where 
outside  considerations  entered  in,  such  as  the  fact  that  a  given 
state  taxes  bonds  and  does  not  tax  stocks,  or  that  manufactur- 
ing plants  must  be  kept  free  of  mortgages  so  that  this  credit  is 
free  to  carry  the  obligations  incurred  in  the  purchase  of  raw 
materials.  As  soon  as  corporations  found  that  a  market  among 
investors  existed  for  these  preferred  stocks,  they  were  issued 
with  steadily  increasing  frequency. 

Difference  Between  Stocks  and  Bonds. — The  difference 
between  stocks  and  bonds  is  fundamental  from  the  point  of 
view  of  economic  theory.  All  stock  stands,  theoretically,  for 
part  ownerships ;  and  the  risks  of  loss  or  gain  belong  appropri- 
ately to  it.  All  bonds,  on  the  other  hand,  represent  loans  and 
have  fixed  interest  rates.  The  holders  of  bonds  are  creditors 
and  their  claims  upon  the  assets  of  the  corporation  at  time 
of  liquidation  take  precedence  over  those  of  the  stockholders. 
From  the  point  of  view  of  the  conduct  of  the  business,  too, 
there  is  a  sharp  demarcation  between  them.  Failure  to  pay 
interest  rates  on  bonds  opens  the  way  to  bankruptcy  or  the 
appointment  of  receivers.  Failure  to  pay  dividends  on  stock 
has  no  effect  on  the  legal  status  of  the  company.  Interest 
payments  of  the  first  sort  are  called  "fixed  charges";  they 
are  a  burden  not  to  be  shifted  to  the  future,  nor  in  any  way 
modified.  Dividends  on  stocks  are  merely  divisions  of  the 
profits,  if  such  exist. 

The  Import  of  Capital  Stock. — Capital  stock,  common 
stock,  or  merely  stock,  represents  invariably  the  interests  of  the 
proprietors  in  the  corporate  enterprise.     In  no  sense  can  stock 


IT  ]  COMMON  STOCK  9 

represent  an  outside  claim;  in  no  sense  can  the  stockholder 
regard  himself  as  a  creditor.  The  fundamental  idea  of  stock 
is  that  it  represents  the  proportionate  contribution  to  the 
original  capital  or  property  of  the  corporation.  Stock  is  the 
share  of  the  ownership,  the  share  of  responsibility  of  manage- 
ment, and  the  share  of  profit  or  loss.  So  far  as  the  com- 
plexity of  modern  business  permits,  the  stockholder  is  the 
business  partner  of  the  old-fashioned  partnership,  but  lacking 
certain  of  the  legal  implications  attending  the  position  of  part- 
ner. The  import  of  capital  stock,  then,  is  that  it  shall  stand  for 
the  representative  values  of  the  proprietary  interests;  represen- 
tative values  which  may  or  may  not  include  the  entire  assets  or 
actual  capital  of  the  corporation. 

On  page  lo  is  an  example  of  a  stock  certificate. 

Types  of  Capital  Stock. — There  are  two  types  of  capital 
stock,  unlike  in  the  extent  of  the  rights  which  the  ownership 
implied  involves.  One  type  of  capital  or  common  stock  stands 
for  the  entire  capital  of  the  business.  The  stockholders  own 
everything.  There  are  no  preferred  shareholders,  no  bond- 
holders, no  short-term  noteholders.  The  Walter  Baker  Com- 
pany, cited  in  the  preceding  chapter,  was  of  this  type.  The 
other  type  represents  merely  the  margin  of  assets  and  earnings 
after  the  claims  of  a  host  of  preferred  stocks,  bonds,  and 
notes  have  been  satisfied.  The  American  Agricultural  Chemi- 
cal Company,  and  the  New  York  Central  Railroad,  described 
in  the  preceding  chapter,  were  of  this  type.  From  every  point 
of  view,  except  that  of  legal  status,  these  two  types  of  common 
capital  stock  must  be  carefully  distinguished. 

The  simpler  form  of  corporation  with  its  single  class  of 
capital  stock  was  developed  logically  and  historically  out  of 
the  partnership.  Capital  stock  of  that  first  type,  representing 
the  entire  business,  was  therefore  prior  in  point  of  time  as 
well   as   first    from   the   standpoint   of   simplicity.      Common 


10 


CORPORATION  FINANCE 


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ni  COMMON  STOCK  II 

stocks  are  now  of  the  first  group — representing  rights  to  the 
entire  property — restricted  to  a  few  small  railroads,  the 
majority  of  Massachusetts  electric  light  and  gas  companies, 
most  small  and  medium-sized  cotton  mills,  locally  owned  manu- 
facturing companies,  banks,  insurance  companies,  and  mines. 
There  have  been  in  almost  every  case  some  special  reasons 
tending  to  hold  back  these  types  of  industry  from  developing 
the  more  elaborate  form  of  capitalization.  Until  recently  the 
tax  laws  in  Massachusetts  levied  a  general  property  tax  on 
bonds,  but  not  on  stocks,  so  that  gas,  electric  light,  and  even 
cotton  mills,  found  a  readier  sale  for  their  tax-exempt  stocks 
among  local  capitalists.  Small  manufacturing  companies 
everywhere  find  the  banks  reluctant  to  extend  credit  to  bonded 
plants;  banks  and  insurance  companies  are  prevented  by  law 
from  altering  the  form  of  their  original  stock  issues ;  mines  find 
it  impossible  to  sell  bonds.  Investors  in  any  of  these  stocks  are 
the  actual  owners  of  the  business,  subject  only  to  the 
claims  of  the  holders  of  floating  debt  and  the  merchandise 
creditors. 

Shares  in  Associations. — Analogous  to  the  common  stocks 
of  corporations  possessing  the  entire  rights  to  the  corporate 
property  are  the  shares  in  associations,  shares  in  trusts,  and 
certificates  of  part  ownership.  Except  in  the  legal  obligations 
taken  by  their  owners,  which  are  analogous  to  those  of  partners, 
these  anomalies  are  common  stocks  in  all  but  name.  The 
certificates  in  associations  are,  in  truth,  certificates  of  partner- 
ship. Owing  to  the  unlimited  liability  that  attaches  itself  to 
such  partnership  interests,  these  certificates  of  associations  are 
not  in  use  anywhere  in  the  United  States,  except  in  the  case 
of  the  large  express  companies  and  certain  small  New  England 
businesses  which  have  maintained  a  kind  of  localized  partner- 
ship character  for  the  last  fifty  or  more  years.  The  Adams  and 
American  Express  Companies  stocks  are  the  only  remaining 


12  CORPORATION  FINANCE  [II 

partnership  shares  widely  held  by  the  public.  These  partner- 
ships were  formed  some  fifty  years  ago — by  means  of  "articles 
of  association"  under  which  the  original  associates  and  their 
successors  agreed  to  engage  in  the  express  business.  The 
management  was  restricted  to  a  small  group  of  officials  which 
organized  and  maintained  itself  independently  of  the  great 
body  of  certificate-holders  or  partners.  In  this  manner  the 
management  of  the  association  was  independent  of  all  regula- 
tion either  from  within  or  without,  and  it  was  not  until  the 
federal  government,  by  the  constitutional  authority  of  the 
"commerce  between  the  states"  provision,  placed  the  express 
companies  under  the  Interstate  Commerce  Commission  that 
any  control  was  exercised  over  the  conduct  of  their  business. 
This  power  of  the  management  to  conduct  the  affairs  of  the 
express  companies  without  financial  responsibility  to  the  share- 
holders has  worked  greatly  to  the  latter' s  disadvantage. 

On  page  13  is  shown  a  stock  certificate  of  the  American 
Express  Company. 

Massachusetts  Trusts. — Shares  of  trust,  or  business 
associations,  survive  only  in  Massachusetts.  Historically  they 
owe  their  origin  to  the  fact  that  corporations  cannot  hold  real 
estate  for  investment  (mortmain).  Title  to  property,  accord- 
ingly, is  taken  by  a  group  of  trustees  who  issue  their  certifi- 
cates of  equitable  interest  in  the  trust  property.  The  trustees 
derive  their  authority  from  trust  agreements  or  articles  of 
association,  which  describe  in  detail  their  powers,  rights,  and 
exemptions,  together  with  those  of  the  certificate-holders. 
When  the  trust  form  of  organization  was  driven  out  of 
other  states  it  remained  in  Massachusetts  because,  sanctioned 
by  a  century  of  usage,  a  large  amount  of  property  had 
passed  under  the  trust  organization  and  the  persons  most 
concerned  exercised  a  strong  influence  on  the  course  of 
legislation. 


II]  COMMON  STOCK  13 


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p3u3isj3^uiio3  ssaiun  pji^A  c^ou  9;'BDgi;j93  sxqx 


14  CORPORATION  FINANCE  [II 

Par  Value. — Capital  stock,  whether  of  the  type  that  re- 
presents all  the  assets  of  the  corporation  or  the  type  that 
represents  merely  the  residual  equity  after  all  other  claims 
have  been  satisfied,  involves  two  distinct  ideas — a  participation 
in  the  rights  of  ownership,  and  a  valuation  of  this  participa- 
tion. This  latter  is  the  par  value.  It  is  the  less  important. 
The  stockholder  can  never  collect,  like  the  bondholder,  the 
par  value  of  his  security  from  the  corporation.  Even  though 
paid  for  in  full  and  representing  for  a  short  time  the  full  and 
actual  value,  the  equality  passes  with  the  first  business  trans- 
action, for  the  value  of  the  property  behind  the  shares  changes 
with  every  step  in  the  success  or  failure  of  the  corporation,  as 
new  property  is  added  or  old  property  lost  or  dissipated.  The 
essential  character  of  capital  stock  that  remains  permanent, 
whatsoever  the  fortunes  of  the  actual  capital,  is  that  it  stands 
for  a  definite  proportion  of  the  corporate  property  and  earn- 
ings. This  involves  no  par  value.  The  purpose  of  stock  would 
therefore  be  fully  accomplished  if  the  shares  were  merely 
proportionate  parts  of  a  total — in  other  words,  shares  without 
par  value. 

Shares  Without  Par  Value. — There  would  be,  aside  from 
doing  away  with  the  meaninglessness  of  "par  value,"  certain 
specific  advantages.  The  most  conspicuous  is  that  of  truth- 
fulness. Without  par  value  there  is  no  pretense  that  the  actual 
property  of  the  corporation  is  equivalent  to  the  par  value  of  its 
shares  after  the  liabilities  are  met,  and  there  is  no  insinuation  of 
overcapitalization  or  undercapitalization.  In  other  words,  the 
capital  stock  would  stand  merely  for  proportionate  shares  in 
the  earnings  of  the  corporation,  and,  if  the  corporation  be 
liquidated,  the  proportionate  shares  in  the  equity  remaining 
after  all  other  claims  had  been  satisfied.  Another  cardinal 
advantage  would  be  that  of  forcing  the  prospective  investor  to 
examine  the  real  value  of  stock,  and  not  be  deluded  into  think- 


Ill  COMMON  STOCK  15 

ing  that  there  is  some  necessary  connection  between  the  par 
value  and  the  real  intrinsic  value. 

A  clear  statement  of  this  advantage  of  truthfulness  is  to 
be  found  in  the  report  of  the  Railroad  Securities  Commission, 
appointed  by  President  Taft. 

We  do  not  believe  that  the  retention  of  the  hundred-dollar 
mark,  or  any  other  dollar  mark,  upon  the  face  of  the  share  of 
stock,  is  of  essential  importance.  We  are  ready  to  recommend 
that  the  law  should  encourage  the  creation  of  companies  whose 
shares  have  no  par  value,  and  permit  existing  companies  to 
change  their  stock  into  shares  without  par  value  whenever 
their  convenience  requires  it.  .  .  .  As  between  the  two  alter- 
natives of  permitting  the  issue  of  stock  below  par,  or  authoriz- 
ing the  creation  of  shares  without  par  value,  the  latter  seems 
to  this  Commission  the  preferable  one.  ...  It  is  less  in  accord 
with  existing  business  habits  and  usages ;  but  it  has  the  cardinal 
merit  of  accuracy.  It  makes  no  claims  that  the  share  thus 
issued  is  anything  more  than  a  participation  certificate. 

At  the  present  time,  January,  1922,  the  corporate  laws  of 
twenty-two  states  permit  the  organization  of  corporations  with 
no  par  value  to  their  shares.  This  represents  quite  a  remarka- 
ble change  of  public  sentiment  when  it  is  remembered  that  the 
first  no-par-value  law  was  passed  in  191 2  by  New  York. 

Full-Paid  Capital  Stock. — Capital  stock  is  usually,  al- 
though not  always,  full  paid.  In  other  words,  the  corpora- 
tion subscribes  to  the  legal  fiction  that  property  to  the  full  par 
value  of  the  stock  was  paid  into  its  treasury  in  exchange  for  the 
shares.  When,  as  is  generally  the  fact,  this  is  not  done  in 
reality,  the  statutes  of  the  various  states  enable  the  directors 
to  pass  a  resolution  to  the  effect  that,  in  their  opinion,  the 
property  received  by  the  corporation  is  worth  the  par  value 
of  the  shares  issued.  As  directors  at  the  inception  of  a  cor- 
poration   are    almost    invariably    irresponsible    lawyers    and 


"I6  CORPORATION  FINANCE  HI 

clerks,  such  opinion  has  no  value  except  that  of  meeting  the 
requirements  of  the  much  abused  statutes.  In  rare  cases,  how- 
ever, the  stock  is  admittedly  not  full  paid.  It  is  then  subject 
to  assessment  for  the  unpaid  balance.  This  custom  seems  at 
present  to  be  restricted  to  Philadelphia  companies  and  to 
Boston  mining  enterprises.  It  is  of  advantage  to  the  corpora- 
tion, because  its  directors  may  call  for  the  unpaid  assessments 
at  any  time,  but  it  interferes  with  the  marketing  of  the  stock 
for  that  same  reason. 

Voting  Powers — Voting  Trusts. — It  is  ordinarily  assumed 
that  the  person  owning  stock  shall  have  the  power  to  vote  at  the 
election  of  the  managing  officers  of  the  corporation.  And  the 
laws  of  certain  states  prevent  a  divorce  between  the  ownership 
and  the  voting  power  of  corporate  shares.  But  in  many  cases 
such  a  divorce  has  actually  taken  place  through  the  medium  of 
the  voting  trust. 

A  voting  trust  is  created  when  the  holders  of  a  substantial 
part,  usually  at  least  a  majority,  of  the  stock  of  a  corporation 
transfer  their  stock  to  certain  trustees,  receiving  in  exchange 
voting  trust  certificates.  These  entitle  their  holders  to  all 
the  privileges  of  stock  ownership  except  that  of  voting.  Any 
dividends  received  by  the  voting  trustees  are  turned  over  to 
the  shareholders,  but  the  latter  exercise  no  control  whatever 
over  the  administration  of  the  corporation. 

The  device  is  of  comparatively  recent  origin  and  has  been 
used  most  commonly  in  connection  with  the  reorganization  of 
a  bankrupt  corporation.  At  such  a  time  the  creditor  interest 
represents  a  far  greater  actual  investment  in  the  corporate 
property  than  does  that  of  the  stockholders.  The  latter  is 
merely  the  shadow  of  an  equity  of  unsubstantial  value.  This 
stock  is  quoted  at  a  low  figure  and  is  held  largely  by  speculators 
and  stockbrokers,  who  have  little  or  no  interest  in  the  perma- 
nent welfare  of  the  corporation.     Yet,  because  of  its  voting 


II]  COMMON  STOCK  17 

power,  these  stockholders  exercise  an  absolute  control  over 
the  property.  They  can  destroy  the  substantial  value  of  the 
creditor  interests  without  losing  much  themselves. 

A  clever  speculator  can  acquire  control  with  little  real  in- 
vestment and  thus  jeopardize  not  only  the  large  interests  of 
the  bondholders  but  also  impede  or  even  seriously  embarrass 
the  recovery  of  the  company.  To  prevent  this,  the  bond- 
holders and  the  minority  stockholders,  or  committees  and 
representatives  of  these  interests,  arrange  that  the  common 
stock,  and  often  the  preferred  as  well,  shall  be  placed  in  a 
voting  trust  to  be  controlled  by  three  or  five  men  well  and 
honorably  known  in  the  business  world.  As  a  result,  all 
interests  are  protected  by  men  whose  responsibility  for  their 
trust  is  publicly  acknowledged  and  who  know  that  the  success 
or  failure  of  the  new  corporation  will  be  laid  by  the  general 
public  directly  upon  them.  Their  reputations  are  at  stake.  As 
one  writer  well  expresses  it : 

The  result  of  the  normal  voting  trust  has  been  to  insure  to  a 
company  both  stability  and  continuity  of  policy,  simple  features 
which  are  often  of  substantial  material  advantage  to  the  con- 
cern and  to  all  its  stockholders.  It  provides  certainty  of  really 
responsible  management.  It  makes  impossible  any  disturbing 
attempts  at  interference  by  minority  stockholders,  w^hich  is  a 
reasonable  and  practical  consideration  to  be  recognized  frankly 
and  at  times  properly.  It  concentrates  on  a  small  group  the 
duty  of  putting  a  concern  into  satisfactory  condition,  giving 
them  both  the  legal  power  and  the  moral  obligation  to  make  a 
real  effort  to  that  end.  It  makes  it  possible  for  those  in  control 
to  formulate  a  well-considered  program  for  the  conduct  of  the 
business  with  the  assurance  that  they  may  remain  unham- 
pered until  the  wisdom  or  futility  of  their  plans  has  been 
demonstrated. 
a 


CHAPTER  III 

BONDS 

Component  Parts  of  a  Bond. — The  fundamental  distinction 
between  the  bondholder  as  a  creditor  of  the  corporation  and 
the  stockholder  as  a  partner  has  already  been  emphasized. 
Yet  among  bonds  there  are  many  distinctions  and  gradations, 
and  the  whole  position  of  the  bondholder  as  a  creditor  is 
usually  hedged  about  by  various  conditions  and  limitations. 

At  the  outset  one  should  remember  that  a  bond  is,  in  truth, 
merely  a  receipt  from  the  corporation  for  a  specific  sum  of 
money — usually  $i,ooo — which  entitles  the  holder  to  partici- 
pate in  the  security  of  a  mortgage  or  other  agreement.  The 
bond,  therefore,  really  consists  of  two  parts.  There  is  the 
piece  of  paper  which  passes  from  hand  to  hand — ordinarily 
spoken  of  as  a  "bond" — which  briefly  summarizes  certain  con- 
ditions of  the  loan,  such  as  the  rate  of  interest  and  the  due  date, 
and  refers  the  owner  to  the  mortgage  for  further  details. 
Then,  secondly,  there  is  the  mortgage  or  agreement,  a  lengthy 
legal  document  which  states  in  great  detail  the  rights  of  the 
bondholders,  the  obligations  of  the  corporation,  and  the 
specific  property,  if  any,  pledged  or  mortgaged  in  security  for 
the  payment  of  the  bonds. 

The  following  represents  the  wording  of  one  of  the  large 
well-known  railroad  bonds : 

united  states  of  america 

Atlantic  Coast  Line  Railroad  Company 

Unified  Mortgage  Fifty  Year  Four  Per  Cent.  Registered  Gold  Bond. 

The  Atlantic  Coast  Line  Railroad  Company,  hereinafter  called 
the   "Railroad   Company,"    for   value   received,   promises   to   pay   to 

l8 


Ill]  BONDS  19 

,  or  registered  assigns,  

Thousand  Dollars  in  gold  coin  of  the  United  States  of  America,  of  or 
equal  to  the  present  standard  of  weight  and  fineness,  on  the  first  day 
of  December,  in  the  year  nineteen  hundred  and  fifty-nine,  at  the  office 
or  agency  of  the  Railroad  Company,  in  the  City  of  New  York,  and  to 
pay  interest  thereon  from  the  first  day  of  June  or  December,  as  the 
case  may  be,  next  preceding  the  date  of  this  bond  (unless  this  bond  be 
dated  June  i  or  December  i,  and  in  that  event  from  the  date  hereof), 
at  said  office  or  agency,  in  like  gold  coin,  at  the  rate  of  four  per  cent, 
per  annum,  in  semi-annual  instalments,  on  the  first  days  of  June  and 
December  of  each  year. 

All  payments  on  this  bond,  both  of  principal  and  interest,  shall 
be  without  deduction  for  any  tax  which  the  Railroad  Company  may  be 
required  to  pay  or  retain  therefrom  under  any  present  or  future  law 
of  the  United  States,  or  of  any  State,  District,  County  or  Municipality 
therein. 

This  bond  is  one  of  a  series  of  bonds  of  the  Railroad  Company, 
coupon  and  registered,  which  shall  not  exceed  in  the  aggregate  Two 
Hundred  Million  Dollars,  all  of  which  bonds  are  issued  or  are  to  be 
issued  under,  and  equally  secured  by,  and  are  subject  to  a  mortgage  or 
deed  of  trust  dated  the  i6th  day  of  November,  1909,  duly  executed  by 
the  Railroad  Company  to  the  United  States  Trust  Company  of  New 
York  as  Trustee.  Reference  is  hereby  made  to  said  mortgage  or  deed 
of  trust  for  a  statement  of  the  property  and  franchises  mortgaged, 
the  nature  and  extent  of  the  securities,  the  rights  of  the  holders 
of  bonds  under  the  same,  and  the  terms  and  conditions  upon  which  said 
bonds  are  issued  and  secured. 

This  registered  bond  is  issued  in  lieu  of,  or  in  exchange  for, 
the  coupon  bonds,  bearing  the  same  rate  of  interest,  whose  numbers 
are  endorsed  hereon,  and  the  coupon  bonds  so  numbered  are  not  issued 
and  outstanding  contemporaneously  herewith. 

This  bond  is  transferable  by  the  registered  owner  hereof,  in 
person  or  by  his  duly  authorized  attorney,  on  the  books  of  the 
Railroad  Company  at  its  said  office  or  agency  in  the  City  of  New 
York,  upon  surrender  and  cancellation  of  this  bond,  and,  thereupon, 
a  new  registered  bond,  having  endorsed  thereon  the  same  serial 
numbers  of  coupon  bonds  as  are  endorsed  hereon,  will  be  issued  to  the 
transferee  in  exchange  herefor ;  or  the  registered  owner  of  this  bond, 
at  his  option,  may  surrender  the  same  for  cancellation  in  exchange  for 
a  like  amount  of  the  principal  hereof  in  coupon  bonds,  bearing  the 


20  CORPORATION  FINANCE  •  [III 

serial  number  or  numbers  endorsed  hereon,  as  provided  in  said  mort- 
gage or  deed  of  trust,  and  on  payment,  in  either  case,  if  the  Railroad 
Company  shall  require  it,  of  the  transfer  charges  therein  provided  for. 

No  recourse  shall  be  had  for  the  payment  of  the  principal  or 
interest  of  this  bond  against  any  stockholder,  officer  or  director 
of  the  Railroad  Company,  either  directly  or  through  the  Railroad 
Company,  by  virtue  of  any  statute,  or  by  the  enforcement  of  any 
assessment,  or  otherwise,  howsoever. 

This  bond  shall  not  be  valid  or  become  obligatory  for  any  purpose 
until  it  shall  have  been  authenticated  by  the  certificate  hereon  en- 
dorsed, of  the  Trustee  under  said  mortgage  or  deed  of  trust. 

In  Witness  Whereof,  Atlantic  Coast  Line  Railroad  Company  has 
caused  these  presents  to  be  signed  by  its  President  or  one  of  its  Vice- 
P-  esidents,  and  its  corporate  seal  to  be  hereto  affixed,  and  to  be  attested 

by  its  Secretary  or  one  of  its  Assistant  Secretaries,  this 

day  of ,  19 

Atlantic  Coast  Line  Railroad  Company, 
By 


President. 
Attest : 


Secretary. 

The  mortgage  referred  to  is  an  elaborate  document,  occupy- 
ing 93  closely  printed  pages  and  explaining,  in  great  detail  and 
with  all  the  sophistry  of  legal  verbiage,  every  possible  phase 
of  the  loan. 

Classification  of  Bonds. — Bonds  differ  most  fundamentally 
in  the  nature  of  the  security  behind  them,  and  the  follov^ing 
classification,  though  not  exhaustive,  will  prove  convenient : 

I.  Bonds    specifically    and    directly    secured    by    property    (mortgage 
bonds) : 
I.  A  first  or  senior  lien  on  specific  physical  property: 

(a)  General  first  mortgage  bonds 

(b)  Divisional  bonds 

(c)  Special  direct  lien  mortgage  bonds 


nil  BONDS  21 

2.  A  secondary  or  junior  lien  on  physical  property: 

(a)  Second  and  subsequent  mortgage  bonds 

(b)  General  and  consolidated  mortgage  bonds 

(c)  Refunding  mortgage  bonds 

3.  A  lien  on  specific  securities  owned  by  the  corporation: 

(a)  Collateral  trust  bonds 

(b)  Secured  short-term  notes 

4.  Equipment  trust  obligations 

II.  Bonds  secured  largely,  if  not  entirely,  by  the  general  credit  of 
the  corporation  (debentures)  : 

1.  Obligatory  promises: 

(a)  Receivers'  certificates 

(b)  Assumed  bonds 

(c)  Guaranteed  bonds 

(d)  Joint  bonds 

(e)  Debentures 

2.  Conditional  promises: 

(a)  Income  bonds 

(b)  Participating  bonds 

Each  of  these  classes  of  bonds  will  now  be  described 
briefly  in  the  next  few  pages. 

I.  Bonds  Secured  by  Property 

I.  First  Mortgage  Bonds. — (a)  General.  A  great  variety 
of  so-called  "first  mortgage"  bonds  exist.  Railroads,  traction 
companies,  lighting  companies,  power  dams,  manufactur- 
ing corporations,  and  even  mines  and  quarries,  have  issued 
their  first  mortgage  bonds.  Yet  from  the  point  of  view 
of  investment  strength,  there  are  great  differences  in  the 
significance  of  the  mortgage  form  of  these  different  classes. 
In  some  cases,  as  with  mines,  the  property  acquired  through 
foreclosure  of  the  mortgage  would  be  almost  worthless, 
because  if  the  mine  could  not  be  made  to  pay  by  the  original 
owners,  the  chances  are  even  less  favorable  for  the  bond- 
holders. On  the  other  hand,  a  railroad,  provided  it  does  not  run 
through  a  desert,  is  practically  sure  of  earning  some  return 


22  CORPORATION  FINANCE  [III 

to  its  bondholders.  It  has  a  fundamental  economic  value 
through  the  monopoly  of  business  given  to  it  by  franchises 
and  mere  geographical  location.  This  economic  value  stands 
for  important  service  to  the  community,  and  is  inextinguish- 
able. Even  the  courts  will  safeguard  it.  For  this  reason 
railroads  have  been  able  to  bond  their  properties  for  a  far 
higher  proportion  of  their  full  value  than  have  other  forms 
of  business  enterprise  not  possessing  the  strategic  industrial 
and  social  importance  of  railroads. 

(b)  Divisional  Bonds.  Divisional  bonds  are  usually  first 
mortgage  bonds  secured  by  a  section  or  division  of  a  railroad's 
property.  They  are  usually  either  the  relics  of  old  bond  issues 
existing  before  a  consolidation  or  a  reorganization,  or  else  the 
still  outstanding  bonds  on  the  integral  parts  of  a  great  system. 
The  idea  has  been  carried  over  into  other  types  of  enterprises, 
so  that  a  bond  on  a  part  of  a  street  railroad,  a  section  of  a 
hydroelectric  company's  transmission  lines,  or  even  a  single 
building  of  a  manufacturing  plant  has  been  called  a  "divisional" 
bond. 

(c)  Special  Direct  Lien.  Special  direct  lien  mortgage  bonds 
are  secured  by  a  direct  first  mortgage  on  real  estate,  land,  termi- 
nal depots,  docks,  wharves,  bridges,  ferries,  and  warehouses. 
Such  real  estate  may  be  owned  by  a  subsidiary  company  and 
leased  to  one  or  more  larger  companies  for  whose  use  it  was 
planned,  or  a  corporation  may  issue  separate  bonds  on  its  real 
estate,  expecting  to  give  a  lower  rate  of  interest  where  it  offers 
that  special  security  than  the  general  credit  of  the  company 
warrants. 

2.  Junior  Lien  Bonds. — (a)  Second  and  Subsequent 
Mortgage  Bonds.  Second,  third,  and  later  mortgage  bonds 
are,  as  their  names  imply,  subsequent  in  their  lien  to  preceding 
bonds.  This  question  of  priority  of  lien,  while  nominally  con- 
cerned with  the  relative  position  of  the  bondholders  at  any 


Ill]  BONDS  23 

division  of  assets,  is  actually  a  matter  of  the  relative  priority 
with  regard  to  the  payment  of  interest.  If  the  earnings  of  the 
corporation  are  ample,  there  is  little  difference  between  a  first 
and  a  seventh  mortgage,  for  the  interest  on  all  issues  is  paid 
before  any  dividends  can  be  set  aside  for  the  stockholder. 
But  if  the  earnings  fall  off  so  as  to  endanger  the  solvency  of 
the  corporation,  the  relative  position  of  the  various  mortgages 
becomes  a  matter  of  primary  importance.  Interest  may  be 
paid  on  the  prior  mortgage  bonds  although  lapsed  on  the  later 
issues;  and  in  the  adjustment  of  sacrifices  at  the  time  of  a 
reorganization,  the  first  mortgage  bonds  are  affected  least  and 
the  later  mortgage  bonds  most.  The  mere  name  does  not 
necessarily  indicate  the  real  character  of  a  bond's  security. 
Especially  is  this  true  of  the  bond  issues  of  the  older  railroad 
systems.  What  purports  by  its  name  to  be  a  third  mortgage 
may  in  fact  be  an  absolute  first  mortgage  by  reason  of  the 
fact  that  the  two  earlier  mortgages  have  been  paid  or  else 
refunded  into  a  later  mortgage.  In  fact,  so  seldom  are  the 
words  "third,"  or  "fourth,"  or  "fifth"  now  used  in  describing 
new  mortgage  bonds,  that  when  such  a  name  appears  it  may 
be  presumed  to  refer  to  some  old  underlying  mortgage  bond 
that  has  withstood  panics  and  reorganizations.  Instead,  there- 
fore, of  implying  weakness,  it  probably  indicates  a  strength 
underlying  the  whole  debt  structure  of  the  corporation. 

(b)  General  and  Consolidated  Mortgage  Bonds.  General 
and  consolidated  mortgage  bonds  are  issued  under  blanket 
mortgages  which  come  after  all  the  preceding  mortgages.  In 
a  large  number  of  instances,  especially  in  the  older  railway 
systems,  the  so-called  "general"  or  "consolidated"  mortgage 
bonds  have  become,  in  effect,  first  mortgages  on  the  entire 
system,  owing  to  the  fact  that  the  earlier  first,  second,  third, 
etc.,  mortgages  have  become  due  and  have  been  paid. 
Ordinarily  a  general  mortgage  bond  agreement  contains  a 
clause  called  the  "after-acquired  property"  clause,  which  states 


24  CORPORATION  FINANCE  I  III 

that  the  mortgage  covers  not  only  the  existing  property  of  the 
corporation  but  that  subsequently  acquired  as  well. 

(c)  Refunding  Mortgage  Bonds.  At  the  present  time  it 
is  common  to  call  general  or  consolidated  open-end  mortgages 
by  the  term  "refunding,"  in  order  to  throw  emphasis  on  the 
fact  that  the  issue  is  designed  primarily  to  pay  off  the  prior 
existing  liens.  Such  a  term  conveys,  to  the  mind  of  the  in- 
vestor, an  implication  that  the  issue  is  of  increasing  security 
and  it  is  therefore  the  more  readily  salable.  After  the  earlier 
issues  have  been  paid  off,  what  purports  to  be  on  its  face 
merely  a  refunding  mortgage  may  be,  in  reality,  a  first 
mortgage.  The  practice  of  refunding  issues  is  of  com- 
paratively recent  prominence.  In  earlier  financial  history, 
complete  refunding  and  unification  was  accomplished  only  at 
the  time  of  a  reorganization,  because  of  the  practical  impossi- 
bility of  inducing  the  holders  of  a  multitude  of  different  issues 
to  consent  voluntarily  to  the  exchange  of  prior  lien  bonds  into 
the  refunding  issue,  while  without  such  exchange  the  equity 
to  the  holders  of  the  refunding  issue  was  so  small  as  to  make 
the  bonds  practically  unsalable.  The  first  great  piece  of  finan- 
cing of  this  kind  was  that  of  the  old  Atchison,  Topeka  and 
Santa  Fe  Railroad  at  the  time  of  the  reorganization  of  1889. 
At  that  time  41  different  issues,  aggregating  over  $160,000,- 
000,  were  refunded  into  two  blanket  issues.  Subsequently,  in 
the  railroad  reorganizations  of  the  middle  nineties,  large 
refunding  issues  were  uniformly  used.  Of  late  years,  especi- 
ally since  1910,  many  railroad  systems  have  discarded  the 
limping  step-by-step  policy  of  financing  improvements  and 
have  issued  instead  great  blanket  refunding  mortgages  of  long 
duration,  with  the  conscious  purpose  of  retiring  all  the  pre- 
viously issued  bonds  and  making  future  improvements  by  the 
sale  of  bonds  secured  by  this  one  general  and  refunding 
mortgage. 

Often  a  little  broader  idea  is  conveyed  by  calling  an  issue 


Ill]  BONDS  25 

an  "extension  and  refunding,"  or  an  "improvement  and  refund- 
ing" mortgage  bond.  Especially  would  such  double  terms  be 
used  if  emphasis  is  to  be  laid  on  the  use  of  some  of  the  new 
money  for  betterment.  Although  large  in  amount,  such  great 
open-end  bond  issues  may  not  be  a  first  lien  on  any  of  the  com- 
pany's property  and  only  an  inferior  junior  lien  on  the  main 
portions.  Thus,  the  great  refunding  and  improvement  mort- 
gage of  the  New  York  Central  is  a  third  lien  on  the  main  lines 
east  of  Buffalo,  a  fourth  lien  on  those  west  of  Buffalo,  and  a 
second  and  third  lien  on  various  branch  lines.  So  far  as  the 
writer  can  discover,  it  is  not  a  first  lien  on  any  physical  prop- 
erty. (The  recent  additions  are  fully  covered  by  the  underlying 
Consolidated  Mortgage  of  1998;  the  stocks  deposited  are  all 
subject  to  prior  liens,  and  the  Beech  Creek  bonds  are  only 
second  liens  on  physical  property. )  The  idea,  however,  in  this 
entire  group  of  bond  issues  is  that  there  exist  underlying  mort- 
gages and  the  general,  the  consolidated,  the  refunding,  the  im- 
provement or  extension  mortgage,  by  whatever  name  it  is 
called,  is  subject  to  all  these  underlying  liens. 

3.  Liens  on  Specific  Securities. —  (a)  Collateral  Trust 
Bonds.  Collateral  trust  bonds  are  secured,  not  by  actual  prop- 
erty but  by  a  lien  on  securities  deposited  with  a  trustee  as  collat- 
eral. Collateral  trust  bonds  have  now  assumed  a  far-reaching 
significance  in  our  American  finance,  a  significance  which  is 
bound  to  increase  as  finjlncial  policies  and  procedures  grow 
more  complex.  They  were  used  at  first  by  railroads  in  order  to 
bring  into  a  single  merchantable  issue  of  bonds  a  variety  of 
divisional  and  branch  bonds  in  themselves  unmarketable 
because  of  their  insignificant  size  or  else  because  some  legal 
obstacle  prevented  the  issue  of  ordinary  bonds.  For  instance, 
the  old  Union  Pacific  Railway,  when  it  was  prohibited  by  the 
United  States  government,  in  1873,  from  issuing  further  direct 
mortgage  bonds  was  involved  in  a  policy  of  extension  in  the 


26  CORPORATION  FINANCE  [III 

Northwest  to  maintain  its  strategic  position.  These  extensions 
were  accordingly  financed  through  the  issue  to  the  parent  com- 
pany of  direct  mortgage  bonds  covering  the  new  construction 
and  those  small  issues  were  made  the  basis  of  a  collateral  trust 
issue  of  bonds  by  the  parent  road.  Since  1906,  their  most 
extensive  use  has  been  in  the  financial  plans  of  public  service 
holding  companies.  Here  the  financial  structure  has,  in  some 
cases,  been  so  complicated  that  collateral  trust  bonds  of  one 
holding  company  are  security  for  those  of  another.  In  one 
or  two  instances  this  process  of  pyramiding  equities  has  been 
carried  up  several  steps. 

(b)  Secured  Short-Term  Notes.  Secured  short-term  notes 
are  usually  merely  short-term  collateral  trust  bonds  which  owe 
their  existence  to  the  demands  of  temporary  financing.  They 
are  a  kind  of  emergency  security  and  the  banker  who  sells 
this  kind  of  bond  usually  insists  that  the  corporation  be  free 
from  underlying  obligations  and  will  agree  not  to  mortgage  any 
of  its  assets  during  the  life  of  the  notes. 

4.  Equipment  Trust  Obligations. — Equipment  bonds  and 
car-trust  certificates  are  together  spoken  of  as  the  "equipment 
obligations."  These  were  used  only  in  railroad  finance  until  a 
year  or  two  before  the  Great  War,  but  the  issue  of  securities 
analogous  to  equipment  obligations  is  now  being  extended  to 
other  corporate  enterprises  having  a  large  amount  of  capital 
tied  up  in  salable  machinery  and  equipment.  Thus  what  was 
until  recently  merely  an  incidental  financial  expedient  now  bids 
fair  to  play  an  important  role  in  American  corporate  finance. 
It  is  virtually  a  method  by  which  the  company  pays  for  new 
equipment  on  the  instalment  plan,  leasing  it  from  the  manu- 
facturer or  from  a  trustee,  who  in  turn  issues  bonds,  paid  off 
as  the  company  makes  its  periodic  payments,  till  finally  all  the 
bonds  are  paid  off  and  the  equipment  passes  to  the  ownership 
of  the  company.    Another  variation  of  the  same  general  scheme 


Ill  ]  BONDS  27 

is  a  series  of  short-term  bonds  issued  by  a  company  itself  at 
the  time  of  purchase  of  new  rolHng  stock,  using  that  stock  as 
security.  Provision  in  the  mortgage  will  call  either  for  a 
periodic  payment  to  a  sinking  fund  or  for  a  periodic  calling 
in  of  a  certain  number  of  bonds,  till  the  full  payment  of  the 
issue,  long  before  the  stock  is  worn  out. 

II.   Bonds  Secured  by  Credit 

I.  Obligatory  Promises. — The  first  bonds  issued  by  the 
railroads  in  England  and  the  United  States  were  based  on  the 
general  credit  of  the  issuing  corporation.  Specific  security  in 
the  form  of  a  mortgage  lien  developed  later,  and  it  may  be 
said  that  in  England  mortgage  bonds  are  relatively  rare  even 
now. 

(a)  Receivers'  Certificates.  When  a  railroad  or  public 
service  corporation,  or  even  a  manufacturing  company,  passes 
into  the  control  of  the  court,  following  threatened  or  actual 
default  on  its  obligations,  the  court  sometimes  authorizes  its 
agents  or  receivers  to  obtain  money  by  issuing  short-term  notes. 
Such  notes  are  known  as  "receivers'  certificates."  They  depend 
for  their  strength  chiefly  on  the  inclination  of  the  court  under 
whose  authority  they  are  issued,  to  enforce  the  final  payment 
of  interest  and  principal,  and  the  courts  will  not  permit  the 
reorganized  railway  corporation  to  assume  the  management  of 
the  property  until  the  receivers'  certificates  are  in  some  way 
provided  for.  Owing  to  their  short  maturity  and  their  anoma- 
lous nature  they  are  not  so  favorably  regarded  by  investors  as 
their  security  would  warrant. 

(b)  Assumed  Bonds.  When  a  purchasing  corporation 
acquires  the  physical  property  of  a  smaller  corporation,  which 
thus  passes  out  of  a  legal  existence,  then  the  purchasing  cor- 
poration automatically  assumes  the  responsibility  for  the  bonds 
of  the  previously  existing  smaller  corporation.     Such  assumed 


28  CORPORATION  FINANCE  [III 

bonds  are,  In  effect,  a  double  obligation  secured,  first,  by  a  direct 
lien  on  specific  property  or  property  rights,  and,  second  by  the 
direct  or  implied  pledge  of  the  general  credit  of  the  corpora- 
tion which  has  acquired  the  property  covered  by  the  direct 
lien.  Assumed  bonds  are  exceedingly  common  in  the  field  of 
American  railroads. 

(c)  Guaranteed  Bonds.  The  commonest  form  of  an  in- 
direct guaranty  of  bonds  is  that  arising  when  one  road  is  leased 
by  another.  The  first  charges  against  the  rentals  will  be  the 
payment  of  interest  charges  on  any  bonds  of  the  leased  road, 
and  so  long  as  the  lease  exists  it  is  a  virtual  guaranty  by  the 
large  road  of  the  payment  of  such  interest  charges,  or  such  an 
agreement  to  pay  interest  charges  may  be  explicitly  given  in 
a  lease.  Except  in  rare  cases  an  explicit  or  direct  guaranty 
is  printed  on  each  bond.  The  guaranty  represents  a  contract 
en  forcible  at  law. 

(d)  Joint  Bonds.  Joint  bonds  ordinarily  arise  through  the 
co-operative  endeavor  of  several  corporations,  particularly 
railroads,  to  build  structures  or  branches  of  road  that  can  be 
used  jointly.  Such  undertakings  include  terminals  in  large 
cities,  wharves,  docks,  bridges  involving  considerable  cost, 
or  connecting  lines  for  the  interchange  of  traffic. 

(e)  Debentures.  Aside  from  assumed  and  guaranteed 
bonds  there  is  a  large  class  of  straight  credit  obligations  un- 
secured by  any  direct  or  indirect  pledge  of  property.  They  are 
called  "debentures."  Such  obligations  are  merely  promises  to 
pay  a  certain  sum  of  money  at  a  given  time.  They  are,  in 
effect,  promissory  notes  resting  solely  on  the  general  credit  of 
the  corporation,  although  it  is  now  customary  for  the  corpora- 
tion to  issue  debenture  bonds  only  under  an  elaborate  legal 
instrument  which  defines  the  conditions  of  their  issue. 

2.  Conditional  Promises. —  (a)  Income  Bonds.  Income 
bonds  involve  no  definite  contract  beween  the  holders  and  the 


Ill  ]  BONDS  29 

trustee  to  insure  the  payment  of  the  interest,  although  the  com- 
pany promises  to  pay  the  principal  at  a  definite  future  time. 
The  interest  is  paid  when  earned,  else  the  holders  of  income 
bonds  can  enforce  their  claim,  but  they  cannot  force  the  cor- 
poration to  pay  the  interest  unless  they  can  prove  that  it  was 
earned  within  the  period  during  which  it  accrued.  It  should 
be  noted  in  passing  that  income  bonds  are  frequently  called 
"adjustment"  bonds  or  even  "preference"  bonds. 

General  Considerations 

These  brief  descriptions  give  the  outlines  only  of  the  security 
really  behind  a  bond.  In  speaking  of  second  and  third 
mortgages  it  was  pointed  out  how  much  stronger  the  security 
may  be  than  first  appears.  In  the  field  of  collateral  trust  bonds 
that  situation  may  be  sharply  reversed.  What  is  given  as  a 
first  mortgage,  may,  as  in  the  case  of  the  old  Rock  Island, 
turn  out  to  be  nothing  more  than  a  first  mortgage  on  a  deposit 
of  the  mere  common  stock,  which  may  or  may  not  represent 
real  value.  Similarly,  but  more  obscurely,  a  first  and  refunding 
mortgage  may  be  found  to  be  a  first  lien  on  only  an  unimportant 
part  of  a  system  that  has  prior  liens  on  the  more  important 
parts  not  included  in  the  refunding  mortgage. 

The  great  disadvantage  of  all  debenture  bonds  is  the 
uncertainty  of  security.  The  purchaser  of  a  debenture  bond 
naturally  judges  the  strength  of  the  issue  by  the  property  and 
earning  power  which  is  unmortgaged.  But  if  the  corporation 
should  exercise  the  legal  right  to  place  new  mortgages  on  the 
property  unmortgaged  at  the  time  of  the  sale  of  the  debenture, 
the  strength  of  the  issue  may  be  undermined  or  perhaps 
destroyed  and  the  holders  of  the  debentures  be  powerless  to 
prevent  it.  The  credit  of  the  Boston  and  Maine  Railroad  was 
so  high  for  years  that  it  borrowed  money  on  its  mere  promise 
to  pay.     But  as  the  credit  of  the   company   declined    from 


30  CORPORATION  FINANCE  [III 

negligence  and  mismanagement  of  its  property,  more  and  more 
of  its  assets  had  to  be  specifically  mortgaged,  so  that  the  prop- 
erty upon  which  the  earlier  creditors  based  their  trust  was 
gradually  withdrawn  from  their  control.  To  guard  against 
this,  the  agreement  under  which  the  debentures  are  issued 
sometimes  specifically  provides  that  no  mortgage  may  be  created 
on  the  property  without  including  the  issue  of  debentures. 

Open  Mortgage  Bonds. — Some  mortgages  allow  of  further 
issues  under  the  same  agreement.  Such  are  called  "open-end" 
mortgages,  and  unless  the  conditions  governing  such  extensions 
are  very  carefully  drawn  the  strength  of  the  bonds  first  issued 
will  be  weakened  by  the  flood  of  later  bonds  of  equal  claims. 
One  condition  that  often  guards  open-end  mortgages  is  the 
requirement  that  the  increase  shall  always  correspond  to  a 
specifically  proportioned  increase  in  the  plants  of  the  cor- 
poration. Another  may  insist  that  net  earnings  of  the  busi- 
ness shall  be  well  above  the  interest  on  the  new  bonds  to  be 
issued. 

Earning  Capacity  as  the  Basis  of  Security. — In  analyzing 
the  value  of  a  given  bond  the  truth  stands  out  that  earning 
capacity  is  the  real  basis  of  security.  The  significance  of  the 
economic  value  of  special  mortgage  bonds,  such  as  those  cover- 
ing only  a  part  of  a  corporation's  property,  is  even  more  sub- 
ject to  individual  qualifications  than  is  the  case  with  general 
mortgage  bonds.  If  the  division  covered  by  the  mortgage  is 
essential  for  the  conduct  of  the  corporation's  business,  the 
bonds  will  be  protected  at  all  hazards.  Even  the  interest  on  the 
first  mortgage  bonds  on  a  large  part  of  a  railroad  system  may 
be  defaulted,  while  that  on  the  underlying  bonds  of  the  im- 
portant divisions  are  paid.  On  the  other  hand,  a  bond  may  be 
of  little  value,  even  though  it  is  the  divisional  bond  of  a  strong 
railroad  system,  for  if  the  division  is  of  no  value  or  a  burden  to 


Ill]  BONDS  31 

the  system  it  may  be  more  expedient  to  force  the  bondholders 
to  take  possession  of  the  property  than  to  pay  interest  on  that 
divisional  mortgage. 

The  strength  of  a  guaranteed  bond  is  similarly  limited  to 
the  earning  capacity  of  the  property  covered  by  the  bonds. 
This  fact  is  clearly  shown  at  the  time  of  reorganization.  If  the 
corporation  making  the  guaranty  fails,  its  receiver  may  con- 
tinue or  repudiate  its  previous  contracts,  among  which  are  its 
various  leases  and  guaranties.  If  the  guaranty  is  unprofitable 
he  will  repudiate  it.  Nor  does  the  larger  corporation  of  neces- 
sity fail  before  it  repudiates  its  guaranty.  It  may  simply  notify 
the  bondholders  that  it  will  be  no  longer  responsible.  They  are 
helpless,  as  the  only  result  of  attempting  to  enforce  the 
guaranty  would  be  to  throw  the  larger  corporation  into  the 
hands  of  receivers,  who  will  then  repudiate  it,  as  they  legally 
may.  Of  course,  so  long  as  the  property  covered  by  the  bonds 
earns  more  than  the  charges,  the  guaranty  will  never  be 
repudiated,  even  during  receiverships. 

The  real  difference  between  some  bonds  with  a  special  lien 
on  railroad  terminals  and  some  bonds  better  classified  as  "joint" 
bonds,  resting  on  the  credit  of  two  or  more  companies,  illus- 
trates the  same  general  principle.  In  the  first  case  the  property 
behind  the  bond  has  genuine  earning  power  of  its  own  in  the 
general  market,  and  in  the  second  the  terminal  has  no  outside 
value  but  will  yield  an  income  only  in  so  far  as  those  particular 
railroad  companies  desire  to  and  are  financially  able  to  rent  it. 
The  wording  of  the  two  types  may  not  vary.  Only  careful 
analysis  of  the  actual  condition  of  the  security  will  make  the 
difference  clear — until  some  time  of  failure  and  reorganization, 
when  the  value  of  the  securities  meets  the  acid  test  of  actual 
earned  capacity. 

The  Denomination,  Interest  Rate,  and  Maturity. — Besides 
security  there  are  other  conditions  of  the  bond  issue,  especially 


32  CORPORATICN  FINANCE  [III 

the  denomination,  the  interest  rate,  and  the  maturity,  which  are 
of  great  importance  aUke  to  the  corporation  and  to  the  investor. 
Earlier  bonds  were  always  of  $i,ooo  denomination,  but  the 
custom  of  issuing  some  of  $ioo  is  now  growing;  it  is  a  whole- 
some custom  for  society  at  large  since  it  gives  the  small  investor 
an  opportunity  to  distribute  his  savings  among  different  in- 
vestments of  high  security. 

The  interest  rate  among  bonds  differs  too  widely  to  allow 
of  any  generalization;  usually  small  coupons  attached  to  the 
bond  itself  state  the  dates  and  amounts  due.  The  most  that 
can  be  said  is  that  the  interest  rate  to  be  paid  is  determined 
largely  by  the  current  custom  with  bonds  of  that  kind  of 
business  and  by  the  desire  to  offer  such  interest  as  will  make 
the  public  willing  to  pay  approximately  par  value  for  the 
bonds.  If  a  rate  higher  than  this  is  offered,  the  bonds  will 
sell  at  a  price  above  par;  if  less,  at  a  price  considerably  below. 
Either  case  is  inconvenient  for  the  bookkeeping  of  the  com- 
pany, and,  in  addition,  a  very  high  interest  rate  burdens  future 
years  with  an  unusually  high  fixed  charge ;  the  low  interest 
rate  and  the  low  market  price  of  bonds  gives  the  company  an 
appearance  of  weakness. 

The  period  from  date  of  issue  to  date  of  maturity — the  time 
at  which  the  principal  borrowed  must  be  returned — may  be 
anything  from  one  to  one  hundred  years.  A  few  bonds  have 
been  issued  in  America  which  were  avowedly  permanent  loans, 
with  no  date  of  maturity,  but  these  are  exceptions.  One  im- 
portant consideration  in  fixing  the  proper  life  period  for  bonds 
is  the  permanence  of  the  security  behind  it.  A  bond  which 
will  outlive  its  security  is,  in  point  of  fact,  a  lien  only  on  the 
general  credit  of  the  company.  Thus  bonds  secured  by  coa^ 
lands,  quarries,  or  standing  timber,  must  be  of  relatively  short 
duration;  whereas  a  bond  received  by  a  hydroelectric  water 
power  of  great  strategic  importance  may  extend  over  many 
years. 


m  ]  BONDS  33 

Convertible  and  Redeemable  Bonds. — Certain  provisions 
sometimes  introduced  into  bond  agreements  are  attempts  to 
give  it  some  of  the  attractions  that  belong  to  the  ownership  of 
stock.  Voting  power  is  rarely  given  to  bonds,  except  in  case 
of  default  of  interest;  but  certain  issues  may  be  converted  at 
the  wish  of  the  owner  into  preferred  or  common  stock.  This 
privilege  gives  investors  an  opportunity  to  watch  the  growth 
of  a  new  company  until  they  are  willing  to  assume  the  risks  of 
proprietorship.  A  management  is  glad  to  make  such  a  pro- 
vision because  the  conversion  of  bonds  into  stock  changes 
fixed  charges  into  contingent  ones. 

A  corporation  may  insert  in  a  bond  agreement  a  provision 
allowing  it  to  pay  the  bonds  in  whole  or  in  part  before  the 
date  of  maturity.  Any  such  promise  works  to  the  advantage 
of  any  remaining  bondholder,  for  it  cuts  down  the  issue  and 
leaves  the  security  the  same.  The  selection  of  the  bonds  to  be 
"called"  first  is  sometimes  by  lot,  sometimes  by  number.  In 
the  latter  case  the  single  issue  of  bonds  is  really  an  issue  of  a 
series  of  bonds  differing  only  in  date  of  maturity. 


CHAPTER  IV 

PREFERRED  STOCKS 

Origin  of  Preferred  Stocks. — It  has  been  pointed  out  already 
that  the  distinction  between  the  stockholder  as  the  partner  of 
the  enterprise  and  the  bondholder  as  the  creditor  was  a  dis- 
tinction of  great  importance  from  every  point  of  view.  Never- 
theless, there  have  grown  up,  principally  since  the  panic  of 
1893,  classes  of  securities  which  are  intermediate  in  relative 
lien  on  the  corporate  property  and  in  priority  to  earnings 
between  mortgage  bonds  on  the  one  extreme  and  common  stock 
on  the  other.  The  most  important  of  these  intermediate  forms 
is  the  preferred  stock. 

The  early  issues  of  preferred  stocks,  say  before  1890,  owed 
their  origin  to  periods  of  corporate  misfortune.  When  a  bank- 
rupt railroad  was  reorganized,  the  lawyers  and  financial 
sponsors  of  the  new  corporation,  then  emerging  out  of 
bankruptcy,  wished  to  issue  a  form  of  security  which  should 
have  a  claim  on  the  earnings  only,  provided  the  earnings  were 
sufficient,  yet  a  claim  that  should  rank  ahead  of  the  almost 
worthless  common  stock  which  they  proposed  to  issue.  Slowly, 
however,  especially  among  promoters  of  industrial  companies, 
the  custom  grew  of  issuing  preferred  stocks  for  investment 
purposes.  Such  issues  seemed  to  give  the  investor  a  larger 
income  than  bonds,  yet  did  not,  like  bonds,  weaken  the  cor- 
poration's banking  or  merchantable  credit,  by  creating  a  direct 
obligation. 

Conditions  of  Issue. — The  conditions  and  limitations  of 
preferred  stocks  may  be  grouped,  roughly,  around  four  central 
ideas.     There  are,  first,  those  conditions  having  to  do  with 

34 


IV]  PREFERRED  STOCKS  35 

the  position  of  the  preferred  stock  in  case  the  corporate  assets 
are  liquidated  or  otherwise  disposed  of.  There  are,  second, 
those  conditions  having  to  do  with  the  hen  on  earnings.  There 
are,  again,  those  conditions  having  to  do  with  the  protection  of 
the  outstanding  preferred  stock  against  future  issues  of  other 
securities  having  a  Hen  on  assets  or  earnings  superior  or 
parallel  to  it.  Finally,  there  are  those  conditions  having  to  do 
with  the  participation  of  the  preferred  stock  in  the  manage- 
ment of  the  corporation.  All  privileges  and  limitations  of 
preferred  shareholders  come  under  one  or  another  of  these 
categories. 

Lien  on  Assets. — The  provision  that  the  preferred  stock- 
holders shall  receive  the  full  par  value  of  their  stock  in  case 
of  liquidation  appears  at  first  glance  as  a  protection  of  great 
moment.  But  a  corporation  does  not  liquidate  its  property 
unless  it  is  in  severe  straits  and  after  every  possible  means  for 
continuing  the  business  has  been  exhausted.  Long  before  that 
time  the  assets  of  the  corporation  have  probably  been  pledged 
or  remortgaged  and  securities  of  all  forms  have  been  placed 
ahead  of  the  preferred  stock,  so  that  if,  finally,  the  point  of 
liquidation  is  reached  there  are  no  assets  left  for  either  pre- 
ferred or  common  stockholders.  But  the  course  of  disaster 
does  not,  ordinarily,  run  to  this  length.  Before  the  affairs 
of  the  company  get  to  such  straits  that  liquidation  is  imminent, 
the  men  in  control  have  either  had  receivers  appointed  or  else 
themselves  proposed  some  plan  of  reorganization.  In  either 
case  the  preferred  shareholders  are  compelled  to  assume  a  part 
of  the  sacrifices  necessary  to  rehabilitate  the  corporation.  Their 
superior  position  over  the  holders  of  the  common  stock  will 
rest  mainly  on  the  skill  with  which  a  committee,  appointed  to 
protect  their  rights,  can  plead  their  cause  at  the  time  of  the 
general  financial  readjustment.  Experience  has  shown  that  in 
the  majority  of  both  industrial  apd  railroad  reorganizations  the 


36  CORPORATION  FINANCE  [IV 

advantages  of   the  preferred   stockholder  over   the   common 
stockholder  are  insignificant. 

Provisions  as  to  Dividends — i.  Rates. — On  the  surface  the 
provisions  affecting  the  dividend,  the  second  class  of  condi- 
tions surrounding  the  issue  of  preferred  stock,  are  of  most 
importance.  These  conditions  usually  define :  ( i )  what  the 
fixed  preferred  stock  dividend  rates  shall  be;  (2)  whether  or 
not  the  dividend  payment  shall  be  cumulative,  that  is,  payable 
later  if  omitted  in  any  one  year;  and  (3)  the  rights,  if  any, 
of  the  preferred  stockholders  to  an  increased  dividend. 

It  is  difficult  to  make  general  statements  covering  preferred 
stock  dividend  rates,  but  as  a  rule  they  vary  according  as  the 
corporation  is  engaged  in  manufacturing,  in  public  service,  or 
in  the  railroad  business.  Except  in  the  group  of  railroad 
preferred  stocks,  the  fixed  dividend  rate  is  usually  higher  than 
the  interest  rate  on  bonds,  even  though  there  exist  no  bonds 
ahead  of  the  preferred  stock.  This  fact  is  based  on  the  widely 
recognized  theory  that  the  preferred  stockholders,  being 
partners  and  not  creditors  of  the  enterprise,  are  entitled  to  a 
larger  return  than  creditors.  Their  stock  involves  a  greater 
risk. 

Rates  for  Industrial  Preferred  Stocks. — The  preferred 
stock  dividend  rates  of  industrial  enterprises  are,  as  a  class, 
highest.  Industrial  companies  are  disinclined  to  issue  bonds. 
Instead  they  seek  to  attract  public  investment  capital  through 
the  issue  of  a  preferred  stock,  and  the  investing  public,  con- 
scious of  the  risks  of  industrial  enterprises,  demands  a  large 
share  of  the  earnings  in  prosperous  years  to  compensate  for 
possible  lapses  of  dividends  during  times  of  scant  profits. 
When  industrial  preferred  stocks  were  first  extensively  issued, 
the  promised  dividend  rate  was  placed  conspicuously  high — 
averaging  upwards  of  8  per  cent.     Subsequently,  especially 


IV]  PREFERRED  STOCKS  37 

after  the  period  of  industrial  promotion  following  the  depres- 
sion of  the  middle  nineties,  the  preferred  stock  dividend  rates 
on  industrials  averaged  somewhat  less  than  it  did  earlier.  By 
far  the  commonest  rate  was  j  per  cent.  This  lowering  of  rate 
was  due,  clearly,  to  the  fact  that  earlier  preferred  stocks  were 
regarded  with  marked  suspicion  by  investors,  while  on  the 
revival  of  business  following  the  financial  crisis  of  1893,  the 
prevalent  optimistic  feeling  toward  business  induced  investors 
to  gauge  industrial  risks  less  rigorously,  so  that  they  were 
willing  to  accept  a  lower  dividend  rate. 

Public  Service  Companies'  Preferred  Stocks. — Preferred 
stocks  among  public  service  companies  have  come  into  existence 
very  largely  since  the  depression  of  1903.  These  are  for  the 
most  part  of  two  classes — those  issued  by  operating  companies, 
and  those  issued  by  holding  companies.  Promoters  of  public 
service  operating  enterprises  retain  for  their  services  the  entire 
common  stock.  They  have  therefore  insisted  on  selling  to  the 
public  a  sufficient  amount  of  securities  to  represent  the  actual 
net  cost  of  the  assets  of  the  corporation.  They  cannot  sell 
enough  bonds  and  therefore  issue,  in  addition  to  the  bonds, 
enough  preferred  stock  to  supply  the  rest  of  the  money.  As 
these  preferred  stocks  are  an  inferior  security,  they  carry  higher 
rates  of  interest  than  the  bonds.  Because  of  this  higher 
promised  return  some  investors  are  willing  to  assume  the  large 
risk.  The  other  class  of  public  service  preferred  stocks,  those 
of  holding  companies,  were  issued  to  supply  the  capital  neces- 
sary to  acquire  control  of  local  operating  companies.  The 
bonds,  and  usually  the  preferred  stocks,  of  these  local  enter- 
prises are  allowed  to  remain  outstanding,  so  that,  owing  to  the 
extent  and  variety  of  the  claims  to  earnings  that  have  pre- 
cedence over  them,  such  preferred  stocks  are  highly  speculative. 
At  the  same  time  they  represent  a  well-diversified  investment, 
drawing  their  income  from  many  and  widely  separated  local- 


38  CORPORATION  FINANCE  [IV 

it.ies.  As  a  general  thing  the  dividend  rate  of  these  preferred 
stocks  is  6  or  7  per  cent.  With  a  market  value  ordinarily  less 
than  the  par  value,  the  yield  to  the  investor  will  average  con- 
siderably greater  than  the  yield  on  the  preferred  stocks  of  local 
operating  enterprises. 

Railroads'  Preferred  Stocks. — As  the  preferred  stocks  of 
railroads  have,  in  the  vast  majority  of  cases,  come  into 
existence  at  times  of  reorganization  or  financial  readjustment, 
the  preferred  dividend  rate  is  usually  low.  These  stocks  were 
issued  as  necessary  expedients  and  were  forced  upon  holders  of 
well-nigh  worthless  securities — hence  there  was  no  need  to 
make  them  attractive  investments.  Owing  to  this  circumstance 
of  their  origin,  fixed  dividend  rates  seldom  exceeded  4  per 
cent,  and  the  average  is  much  lower  than  the  rates  on  public 
service  and  industrial  companies'  preferred  stocks, 

2.  Cumulative  Dividends. — A  way  of  attempting  to  give 
preferred  stock  the  apparent  strength  of  bonds  is  to  state  in  the 
stock  certificate  that  any  lapsed  payment  of  one  year  shall  be 
made  up  in  later  years  before  the  holders  of  common  stock 
receive  dividends.  Such  a  cumulative  clause  is  of  rather  more 
apparent  than  real  advantage,  as  it  gives  an  incentive  to  strain 
the  resources  of  the  company  for  the  regular  payment  of 
dividends,  and  perhaps  hurt  the  permanent  prosperity  on  which 
the  real  value  of  the  preferred  as  well  as  the  common  stock 
depends.  On  the  other  hand,  the  cumulative  clause  may  protect 
the  preferred  stockholders  from  the  policy  of  the  board 
of  directors  to  build  up  gradually  a  large  hidden  reserve  for 
the  benefit  of  the  common  stockholders,  the  real  owners  of  the 
equity,  before  they  declare  dividends  on  either  class  of  stock. 

The  diversity  of  stock  claims  to  dividends  may  be  com- 
plicated by  dividing  the  entire  preferred  stock  into  several 
issues.      The   most    frequent   combination    is    a    7   per   cent 


IV]  PREFERRED  STOCKS  39 

cumulative  first  preferred  and  a  6  per  cent  non-cumulative 
second  preferred  stock.  The  former  is  sold  as  a  high-grade 
investment  security  and  the  latter  as  a  stock  but  little  more 
assured  of  its  dividend  than  the  common  stock  and  without 
the  latter's  speculative  possibilities.  The  motive  seems  to  be 
to  create  a  relatively  small  issue  of  a  first  lien  preferred  stock — 
occupying  a  position  analogous  to  bonds — upon  which 
dividends  can  be  almost  positively  assured,  and  also  a  large 
issue  of  stock  little  better  in  its  claim  on  earnings  than  common 
stock,  yet  a  stock  issue  without  the  ordinary  management 
rights  of  the  common  stock. 

3.  Rights  to  Increased  Dividends. — An  attempt  to  give  the 
preferred  stock  more  of  the  attractiveness  that  goes  with  the 
hope  of  extra  profits  takes  the  form  of  an  arrangement  which 
permits  the  preferred  stockholder  to  share  with  the  common 
stockholder  in  any  disbursements  after  the  common  stockholder 
has  received  an  amount  equal  to  that  of  the  holder  of  the  pre- 
ferred stock.  The  arrangement  is  very  frequent  among  rail- 
road preferred  stocks,  but  comparatively  rare  among  industrials. 
Sometimes  the  conditions  are  made  more  complicated,  as  when 
the  preferred  stockholders  first  receive  a  definite  amount,  then 
the  common  the  same  rate,  after  which  the  dividends  on  both 
classes  increase  by  successive  steps.  It  is  clear  from  these  ex- 
amples that  almost  any  variation  in  the  dividend  specifications 
of  a  preferred  stock  contract  can  be  made,  and  in  practice  it 
is  possible  to  find  an  example  of  every  conceivable  variety. 
Usual  variations  of  the  dividend  contracts  are  very  fre- 
quently attached  to  the  preferred  stocks  of  small  industrial  com- 
panies of  Massachusetts  and  Connecticut  in  order  to  make 
their  issues  attractive  to  investors. 

Chief  Weakness  of  Preferred  Stocks. — Although  seem- 
ingly the  most  significant  of  the  various  qualifications  of  pre- 


40  CORPORATION  FINANCE  I IV 

ferred  stock,  the  conditions  of  dividend  payment  are  not  as 
important  as  tliose  that  should  protect  the  preferred  stock 
itself  from  future  weakening  through  the  subsequent  issue  of 
new  securities  having  a  superior  or  equal  lien  on  the  property. 
The  chief  weakness  of  preferred  stocks  as  investment  securi- 
ties lies  in  the  ease  with  which  an  unscrupulous  or  improvident 
management  may  place  bonds,  notes,  and  bank  debts  ahead  of 
an  already  existing  issue  of  preferred  stock  sold  originally  on 
the  assumption  that  there  were  no  prior  liens.  The  preferred 
stockholders  in  a  corporation  are  usually  investors  whose  con- 
cern in  the  management  is  indirect.  In  the  intent  of  their 
position  they  are  partners,  and  they  are  forced  by  the  law  to 
take  the  responsibility  of  partners;  in  reality  they  have 
ordinarily  as  little  to  do  with  the  actual  conduct  of  the  enter- 
prise as  bondholders.  For  this  reason  they  are  entitled  to 
some  measure  of  protection  against  the  ill  results  of  a  busi- 
ness policy  for  which  they  are  only  theoretically  responsible 
and  the  most  vitally  important  protection  is  that  which  safe- 
guards them  against  the  dissipation  of  the  assets  of  the 
business. 

When  the  preferred  stockholder  first  acquires  his  shares 
he  is  mindful  of  the  condition  of  the  business  at  that  time. 
Perhaps  there  are  no  bonds  or  notes  ahead  of  this  stock,  as  in 
the  case  of  many  issues  of  industrial  preferred  stocks.  He 
relies  for  protection  on  the  continued  priority  of  the  position 
of  his  security,  knowing  that  a  corporation,  once  established  on 
so  firm  a  footing  as  to  attract  investors  to  the  purchase  of  its 
preferred  shares,  does  not  commonly  become  bankrupt  through 
the  routine  conduct  of  its  business.  This  is  conspicuously  true 
of  water,  gas,  and  electric  light  operating  companies  where 
there  are  a  few  well-protected  preferred  shares  which  have 
almost  the  investment  standing  of  bonds.  A  disaster  comes, 
if  at  all,  through  unwise  extensions.  The  managers,  who  may 
own  only  the  common  stock,  become  intoxicated  with  their 


IV I  PREFERRED  STOCKS  4I 

success  in  a  small  way,  and  falsely  assume  that  still  greater 
success  will  follow  extension.  They,  being  owners  of  the 
common  stock,  have  everything  to  gain  through  extension,  and 
nothing  to  lose ;  the  preferred  stockholders,  being  limited  in  the 
amount  of  their  dividends,  have  everything  to  lose  through 
the  failure  of  these  extensions,  and  nothing  to  gain  through 
their  success.  It  is  to  their  advantage  that  the  business  should 
be  small,  compact,  and  able  to  resist  depression  and  possible 
tightness  of  the  money  market.  It  is  this  diversity  of  interest 
between  the  common  and  preferred  shareholders,  while  the 
managing  control  remains  with  the  former,  that  constitutes  the 
real  and  fundamental  weakness  of  preferred  shares  as  invest- 
ment securities. 

Preferred  Stocks  and  Depreciated  Inventories. — This  is 
not  of  mere  theoretical  importance.  It  is  a  matter  of  import  to 
the  soundness  of  American  finance.  During  the  period  of  the 
Great  War,  industrial  companies  made  great  profits.  In  order 
to  carry  large  inventories  of  expensive  raw  materials  bought 
at  inflated  prices,  they  sold  preferred  shares  to  investors  and 
borrowed  heavily  from  commercial  banks.  In  the  autumn 
of  1920,  and  during  1921,  these  same  raw  materials  fell 
precipitously  in  value,  orders  of  manufactured  goods  were 
canceled,  and  merchandise  could  not  be  sold.  The  liberal 
margins  protecting  the  preferred  shareholders  when  the  stocks 
were  sold  were  entirely  wiped  out  by  the  fall  in  the  value  o " 
the  inventories — yet  the  banks'  loans  had  to  be  paid.  In 
literally  innumerable  cases  the  preferred  stock  dividends  were 
"passed"  and  in  many  cases  large  issues  of  notes  or  bonds 
were  placed  ahead  of  the  preferred  stocks  in  order  to  fund 
the  excessive  floating  debt  occasioned  by  the  heavy  losses  in 
inventories.  In  brief,  the  disaster  caused  by  the  improvident 
management  of  the  directors  was  passed  directly  on  to  the 
shoulders  of  the  preferred  shareholders. 


42  CORPORATION  FINANCE  I IV 

Protection  from  Note  and  Bond  Issues In  very   rare 

cases  the  directors  are  prohibited  by  the  by-laws  of  the  cor- 
poration from  incurring  any  floating  debt  at  all.  Ordinarily 
there  is  nothing  in  the  preferred  stock  contract  that  restricts 
the  creation  of  an  unlimited  floating  debt,  except  that  sometimes 
a  reasonable  surplus  must  be  created  before  any  dividends  may 
be  paid  upon  the  common  stock. 

It  is,  however,  quite  common  for  the  preferred  stock  to  be 
protected  against  the  issue  of  bonds,  which  would  take  prece- 
dence over  the  stock.  This  is  usually  accomplished  by  requir- 
ing that  no  new  bond  issue  or  mortgage  shall  be  authorized 
without  the  consent  of  a  large  percentage  of  the  outstanding 
preferred  stock.  Sometimes  it  is  stipulated  that  no  mortgage 
whatsoever  shall  be  placed  on  the  company's  property.  In  the 
case  of  preferred  shares  of  holding  companies  it  is  necessary 
to  provide  that  the  fundamental  assets  behind  the  preferred 
shares  shall  not  be  destroyed  by  permitting  the  subsidiary  com- 
panies to  issue  their  own  mortgages  or  notes  which  "cut  in 
under"  the  lien  of  the  holding  company's  preferred  shares.  In 
spite  of  legal  precautions,  however,  instances  have  been  known 
in  which  the  directors  have  vitiated  these  wholesome  protec- 
tions for  the  preferred  shareholders  by  guaranteeing  the  princi- 
pal and  interest  of  bonds  of  other  companies.  If  the  latter 
fail,  such  obligations  assume  priority  over  the  preferred  stock 
in  the  reorganization  plans. 

Protection  from  Further  Stock  Issues. — It  is  quite  usual 
to  provide  that  the  preferred  stock  shall  not  be  increased  with- 
out the  separate  consent  of  the  preferred  stockholders  them- 
selves. This  restriction  is  frequently  embraced  in  a  provision 
that  the  proposal  to  authorize  new  preferred  stock  shall  be 
submitted  to  a  meeting  of  the  preferred  stockholders  called 
especially  for  the  purpose.  Recently,  it  has  become  the  custom 
to  defeat  this  entirely  wholesome  provision  by  creating  at  the 


IV]  PREFERRED  STOCKS  43 

outset  SO  large  an  authorized  but  unissued  preferred  stock  issue 
as  to  render  unnecessary  any  consent  from  the  preferred  stock- 
holders for  subsequent  issues.  In  very  rare  instances  it  is 
provided,  as  with  open-end  mortgages,  that  the  prospective 
dividends  on  new  preferred  stock  shall  not  endanger  the 
stability  of  the  dividends  on  the  old  preferred  stock.  This  can 
be  easily  done  by  requiring  that  the  net  earnings,  after  charges, 
and  the  accumulated  surplus  shall  be  ample  to  meet  the  new 
preferred  dividends  as  well  as  the  old. 

Management  Rights. — Ordinarily  the  preferred  stock  has 
the  same  privilege  as  the  common  stock  in  the  election  of 
directors  and  other  administrative  matters.  This  practice  has 
been  generally  followed  in  most  of  the  railroad  and  large 
industrial  issues,  although  there  are  notable  exceptions.  The 
most  frequent  exception  to  the  rule  is  the  exemption  of  the 
preferred  stockholders  from  any  control  whatever,  on  the 
theory  that  the  preferred  stockholders  are  merely  investors  in 
the  company's  securities  for  income  in  the  same  manner  as 
bondholders.  In  such  cases,  however,  it  is  usually  provided 
that  if  the  preferred  stock  dividend  is  not  regularly  paid,  the 
preferred  stockholders  obtain  voting  rights  and  may  even 
elect  a  majority  of  the  board  of  directors. 

Contrasted  with  this  exclusion  from  the  management  are 
instances  in  which  the  preferred  stockholders  are  given  actual 
control  of  the  enterprise.  Intermediate  between  the  exclusion 
of  the  preferred  stockholders  from  a  voice  in  the  management 
and  the  control  by  them,  is  the  provision  that  the  two  classes 
of  shareholders  have  equal  voice  in  the  management  until  the 
preferred  stock  dividend  ceases.  Then  the  preferred  stock 
is  privileged  to  elect  a  majority  of  the  directors.  Often, 
especially  after  reorganizations,  the  preferred  shareholders 
will  be  given  the  control  until  the  payment  of  their  dividends 
seems  assured. 


CHAPTER  V 

THE  PROMOTER  AND  BANKER 

Individual  Nature  of  Financial  Problems. — The  great 
variety  of  forms  in  the  securities  offered  the  investing  public 
has  risen  out  of  the  specific  needs  of  the  managers  of  actual 
corporations.  There  are  no  stereotyped  rules  to  define  the 
original  arrangement  of  stocks  and  bonds  of  any  corporation; 
there  are  none  for  deciding  when  to  pay  and  when  not  to  pay 
dividends,  when  and  how  to  expand,  or  how  to  set  a  broken 
down  corporation  on  its  feet  again.  All  these  are  questions 
of  good  judgment  to  be  determined  in  each  separate  case. 
Certain  customs  have,  however,  been  established,  usually  with 
the  indorsement  of  experience  behind  them.  These  customs 
vary  with  the  type  and  size  of  the  business  and  are  influenced 
often  by  state  laws  that  directly  or  indirectly  affect  the  issue 
of  securities. 

Conflicting   Viewpoints   of   Promoter    and    Investor. — In 

starting  an  enterprise,  later  in  determining  its  dividend  policy 
or  seeking  to  rehabilitate  it,  the  two  points  of  view  spoken  of  in 
the  first  chapter  must  be  kept  in  mind.  On  the  one  side  is  the 
management  of  the  corporation  with  its  ever-recurring  need 
of  capital,  its  desire  to  be  free  from  fixed  obligations,  and, 
probably,  its  own  special  interests  in  maintaining  the  value  of 
the  common  stock  and  in  keeping  control.  On  the  other  side 
there  is  the  investor's  somewhat  conflicting  point  of  view — 
often  varying  in  relative  strength  with  the  social  mood  of  the 
hour,  but  all  the  time  directed  toward  protecting  his  savings 
and  getting  from  the  corporation  a  large  yearly  return.  Thus, 
in  issuing  any  new  securities,  whether  at  the  time  of  promotion 

44 


V]  THE  PROMOTER  AND  BANKER  45 

or  for  a  later  need,  the  management  must  offer  something  "at- 
tractive" and  at  the  same  time  must  keep  the  general  structure 
of  the  corporation  so  well  balanced  that  interest  charges  will 
not  be  such  a  burdensome  drain  on  the  earnings  of  the  corpora- 
tion as  to  interfere  with  the  best  conduct  of  the  enterprise. 

Critical  Attitude  of  Investors  at  Promotion. — Investors 
holding  the  securities  of  established  companies  ordinarily  pay 
little  attention  to  the  actual  business,  concerning  themselves, 
if  at  all,  only  with  the  most  obvious  details  such  as  present  and 
past  earnings,  the  proportion  of  the  net  earnings  absorbed 
by  interest  charges,  and  the  proportion  available  for  dividends. 
Once  the  corporation  has  been  established  and  its  securities 
distributed  it  is  easy  to  satisfy  most  investors  about  the 
financial  condition  of  a  company.  This  is  not  true,  however, 
at  the  beginning.  At  the  formation  of  a  new  company, 
whether  formed  to  exploit  a  new  idea  or  to  do  something 
already  done  by  others,  every  prospective  investor  wants  to 
know  a  good  deal  about  the  enterprise.  The  company  must 
make  a  place  for  itself  and  establish  itself  in  public  confidence. 
Everyone  is  skeptical  about  it,  except  its  incorporators. 

Functions  and  Types  of  Promoters. — The  questioning, 
critical  attitude  never  of  itself  leads  to  action.  One  person  at 
least  will  be  convinced  of  the  value  of  the  new  project  before 
it  gets  to  the  form  of  a  specific  plan,  or  the  corporation  will 
never  even  be  projected.  This  one  person,  in  whose  brain 
first  arises  the  idea  of  the  enterprise,  is  called  the  "promoter." 
He  plays  the  part  of  the  father  or  sponsor  of  the  enterprise. 
This  promoter's  part  may  be  played  by  a  man  usually  busy  in 
the  detail  of  manufacturing  or  of  engineering  work,  or  by  a 
banker  who  may  think  out  the  plan  for  organizing  a  new 
combination  of  small  companies.  Often  it  will  be  played  by 
a  man  who  makes  such  promotion  his  main  business  and  who 


46  CORPORATION  FINANCE  {V 

never  expects  to  keep  a  permanent  interest  in  the  management 
of  the  child  of  his  imagination.  It  may  even  be  played  by  an 
irresponsible  get-rich-quick  gentleman  who  seeks  to  get  others 
to  pay  the  cost  of  exploiting  some  new  idea  for  his  own 
benefit.  There  are  various  types  of  such  professional  pro- 
moters and  unfortunately  much  has  appeared  in  fiction  and  in 
newspapers  to  create  in  the  public  consciousness  the  impression 
— often  verging  on  a  conviction — that  all  promoters  are  by 
nature  impecunious,  silvery-tongued  vendors  of  worthless 
shares  in  mining  and  oil  projects.  There  are  such,  it  must 
be  admitted,  but  their  notoriety  far  exceeds  their  number  or 
their  importance. 

Usual  Characteristics  of  Promoters. — The  promoter  who 
actually  takes  a  significant  part  in  modern  industrial  progress 
is  a  man  of  the  strictest  honesty.  Temperamentally  he  is  an 
optimist,  open-minded  to  new  suggestions,  but  skeptical  of 
statements  not  based  on  concrete  experience;  critical,  in  the 
sense  of  being  analytical  and  suspicious  of  human  nature,  but 
uncritical  in  the  sense  of  being  free  from  the  fetters  of  con- 
vention and  tradition.  Such  a  man  must  possess  imagination. 
His  is  the  constructive  imagination  that  is  an  essential  part  of 
business  genius.  The  great  promoter  has  an  intuitive  ap- 
preciation of  social  needs  and  the  manner  in  which  they  affect 
business.  He  is  not  interested  in  the  theory  of  economic  laws, 
yet  he  can  forecast  movements  in  the  supply  and  demand  of 
a  commodity,  and  project  into  the  future  the  effects  that  fol- 
low in  the  wake  of  a  new  business  enterprise.  It  is  this  pro- 
phetic imagination  of  the  promoter  that  blazes  the  paths  of 
industrial  progress.  By  means  of  the  economic  changes  that 
follow  in  the  march  he  leads,  civilization  moves. 

Criticism  of  Bankers. — The  promoter  leaves  the  exact 
structure  and  the  form  of  financial  organization  of  the  new 


VI  THE  PROMOTER  AND  BANKER  47 

corporation  entirely  in  the  hands  of  the  investment  banker,  if 
he  can  find  one,  who  will  help  to  raise  the  necessary  capital. 
The  promoter  must  expect  to  meet  with  searching  criticism 
from  bankers  before  they  are  willing  to  indorse  his  enterprise, 
and  he  must  submit  his  own  estimates  to  the  analyses  of  their 
specially  chosen  experts  who  will  report  on  all  questions  of 
cost  and  construction. 

The  vast  majority  of  projects  conceived  by  promoters  are 
never  accepted  by  bankers  or  capitalists.  The  usual  reason 
for  the  rejection  of  a  legitimate  enterprise  by  bankers  is  that, 
in  their  business  judgment,  the  new  enterprise  does  not  seem 
to  be  in  a  position  to  meet  an  already  existing  economic  demand 
at  a  price  that  will  render  the  company  profitable.  Often  the 
weakness,  from  the  business  point  of  view,  is  the  prohibitive 
cost  of  production.  There  is  an  enormous  demand  for  auto- 
mobiles that  is  not  yet  satisfied — and  probably  never  will  be — 
but  an  enterprise  which  was  projected  with  a  view  to  satisfying 
this  demand  would  be  rejected  by  any  banker  because  the 
satisfaction  of  the  demand  would  involve  the  production  of 
automobiles  at  so  low  a  level  of  cost  as  to  render  the  business 
technically  impossible.  On  the  other  hand,  bankers  often  fail 
to  appreciate  the  social  and  economic  need  of  a  new  invention. 
Bell  and  his  associates  found  it  impossible  to  secure  the  co- 
operation of  any  bankers  at  the  time  of  the  promotion  of  the 
telephone,  not  because  of  doubts  concerning  the  telephone 
itself  but  because  of  doubts  of  the  existence  of  an  economic 
demand  for  telephones.  Subsequently,  after  Bell  and  his 
associates  had  convinced  the  public  of  the  economic  demand 
for  telephone  service,  new  companies  sprang  up  in  all  sections 
of  the  country  seeking  to  take  advantage  of  this  newly  created 
demand.     Bankers  then  supplied  the  campaign  with  capital. 

Intuitive  Judgment  of  Trained  Bankers. — So  thorough  and 
strict  is  the  criticism  offered  by  bankers  that  probably  not  more 


48  CORPORATION  FINANCE  [V 

than  one  in  ten  of  the  projects  submitted  are  accepted  as  good 
"working  propositions."  A  trained  banker  seems  to  scent  in- 
tuitively the  enterprise  which  will  be  successful.  This  precision 
of  what  one  might  call  "intuitive  judgment"  is  largely, 
although  not  entirely,  based  on  the  banker's  insight  into  the 
business  ability  and  integrity  of  the  promoter.  Luck  has  little 
to  do  with  it — Adam  Smith  stated  that  good  and  bad  luck 
belonged  to  the  vocabulary  of  small  shopkeepers.  The  fact 
that  successful  bankers  thoroughly  trained  in  their  business 
almost  invariably  select  successful  enterprises  with  which  to 
identify  themselves,  while  others  have  an  equal  partiality  for 
enterprises  that  ultimately  result  in  failure,  is  not  a  matter  of 
chance,  nor  is  it  the  result  of  the  normal  accidents  and  hazards 
of  the  business  world.  Investment  bankers  must  feel,  with 
extreme  sensitiveness,  the  intangible  atmosphere  that  surrounds 
every  enterprise.  They  lay  far  greater  stress  upon  the  intel- 
lectual and  moral  capacities  of  the  men  associated  with  the 
prospective  enterprise  than  they  themselves  recognize  or  are 
willing  to  admit  to  their  clients. 

The  conspicuously  successful  operators  in  any  stable  line 
of  industry — and  the  number  for  each  industry  can  in  all 
probability  be  counted  on  the  fingers — can  secure  any  reason- 
able amount  of  capital  at  any  time  from  any  one  of  a  compara- 
tively large  group  of  bankers.  This  statement  is  especially 
true  of  successful  operators  of  electric  light  and  power  com- 
panies, of  railroads,  and  of  cotton  mills.  Some  men  cannot 
secure  capital  from  bankers  at  any  time,  even  though  their 
enterprises  are  objectively  sound.  All  of  this  means  that  a 
successful  promoter  who  can  win  the  backing  of  investment 
bankers  of  standing  willing  to  furnish  him  with  the  requisite 
capital  must  have  marked  ability  and  high  business  integrity. 

The  Banker's  Reputation. — The  banker  knows  that  his 
own  chief  asset  is  this  reputation  for  good  judgment  coupled 


V]  THE  PROMOTER  AND  BANKER  49 

with  his  Stalwart  honesty.  The  good-will  reflected  in  the  success 
with  which  he  directs  investments  brings  customers  to  him  for 
advice  and  enables  him  to  sell  the  securities  he  has  to  offer. 
He  protects  this  reputation  by  every  safeguard  and  every  pos- 
sible outside  aid  to  his  own  judgment.  He  will  call  in  the 
help  of  expert  accountants,  of  engineers,  of  patent  attorneys, 
and  of  corporation  lawyers.  But  after  all  these  experts  have 
rendered  their  reports  the  ultimate  judgment  must  remain  with 
the  banker  himself.  He  alone  is  responsible  in  the  end ;  he  can- 
not shift  the  burden.  And  he  recognizes  this  fact.  He  knows 
that  if  the  enterprise  fails  he  cannot  excuse  himself  on  the 
ground  of  an  engineer's  faulty  judgment  or  of  the  error  of  an 
accountant  or  a  lawyer.  For  instance,  a  few  years  ago  Boston 
banking  interests  promoted  an  inter-urban  traction  company 
in  the  West.  Reputable  lawyers  asserted  that  the  franchises, 
rights,  and  titles  upon  which  the  road  was  built,  were  sound. 
After  operation  had  commenced,  the  road  was  sued  for 
damages  on  the  ground  that  it  crossed  the  previously  granted 
right  of  way  of  a  railroad  corporation,  which  existed  only  on 
paper.  The  bankers  could  not  hide  behind  the  blunder  of  the 
lawyers,  because  they  were  responsible  for  hiring  the  lawyers. 
In  the  end  the  success  of  a  banker  is  reflected  in  social  rather 
than  personal  terms.  He  succeeds  according  as  he  is  able  to 
conserve  the  resources  of  society  by  selecting  for  his  indorse- 
ment those  enterprises  which  supply  an  economic  need  and 
have  a  social  justification,  though  to  the  promoter  he  often 
seems  overcautious  and  a  hamper  to  progress.  Through  the 
motive  of  safeguarding  his  own  funds  and  his  own  reputation 
he  really  safeguards  the  savings  of  society. 

Determination  of  the  Financial  Plan. — The  exact  pro- 
cedure in  starting  a  corporation  and  the  arrangement  of  stocks 
and  bonds  to  be  issued  will  vary  according  to  circumstances. 
The  plan  to  be  followed  in  exploiting  an  entirely  new  invention 


50  CORPORATION  FINANCE  [V 

is  quite  different  from  that  to  be  followed  in  starting  a  new 
concern  in  an  established  business;  and  that  again  differs 
materially  from  the  procedure  of  combining  a  group  of  small 
concerns  into  a  single  corporation,  whatever  the  type  of  busi- 
ness. This  difference  is  most  marked  in  the  methods  used  for 
selling  the  first  securities,  that  is,  for  getting  the  initial  capital. 
The  investment  banker,  on  whose  recommendation  the  small 
investor  depends,  will  have  nothing  to  do  with  the  promotion  of 
certain  kinds  of  enterprises,  for  the  project  is  in  a  field  so 
untried  that  it  offers  a  degree  of  risk  he  cannot  properly  advise 
another  to  take.  The  big  or  little  investor  who  trusts  to  his 
own  judgment  must  be  called  on  to  take  the  initial  risk 
of  furnishing  the  first  capital.  When  the  banker  does  act 
as  financial  sponsor  of  the  new  corporation,  he  will  have  much 
to  do  with  determining  the  securities  to  be  issued. 

A  discussion  of  the  machinery  of  the  promotion  of  cor- 
porations falls  most  conveniently  into  topics  arranged  accord- 
ing to  the  nature  of  the  business.  New  enterprises  with  new 
products  differ  from  new  corporations  in  old  lines  of  business, 
except  that  a  few  types  of  enterprise,  such  as  mining,  are  by 
their  very  nature  working  always  in  an  untried  field.  The 
methods  of  marketing  securities,  whether  of  new  corporations 
or  of  old,  are  quite  generally  the  same.  But  in  other  aspects 
of  their  promotion,  manufacturing  enterprises  are  best  treated 
apart  from  all  public  service  corporations.  Railroads  further 
differ  in  important  respects  from  the  narrower  field  of  public 
utilities — the  gas,  water,  and  electric  light  plants.  It  is  con- 
venient, therefore,  to  discuss  separately  the  financial  plans 
to  be  followed  in  the  promotion  of  these  different  types  of 
enterprise. 


CHAPTER  VI 

THE  PROMOTION  OF  NEW  ENTERPRISES 

Stages  in  Promotion — All  business  enterprises,  as  has  been 
said,  owe  their  existence  in  the  beginning  to  the  imagination 
of  some  one  man.  Very  frequently  he  co-operates  with  others, 
so  that  the  original  plans  appear  to  be  the  results  of  the  joint 
efforts  of  a  group  of  men.  The  American  Telephone  and 
Telegraph  Company  owes  its  existence  to  the  imagination  of 
Alexander  Graham  Bell  and  his  enthusiastic  confidence  in  the 
commercial  adaptability  of  the  telephone,  but  the  success  of 
the  company  in  its  earliest  years  was  due  quite  as  much  to  the 
financial  skill  of  another  man,  the  advertising  ability  of  still 
another,  and  the  remarkable  power  of  organization  of  yet 
another. 

In  general,  there  are  five  stages  in  the  promotion  of  a 
business  enterprise.  The  first  is  the  conception  of  the 
enterprise  by  the  promoter;  the  second  is  the  working  up  of 
the  details  of  the  enterprise,  again  by  the  promoter ;  the  third 
is  the  formulation  of  the  financial  plan,  usually  the  joint  effort 
of  the  promoter  and  the  banker;  the  fourth  is  the  formation 
of  an  underwriting  syndicate  by  the  banker;  and  the  last  is  the 
sale  of  the  securities  of  the  enterprise  to  the  public,  from  whom 
ultimately  the  capital  is  obtained.  But  in  the  promotion  of  a 
company  undertaking  some  entirely  new  enterprise  the  third 
and  fourth  steps  are  omitted,  for  in  such  enterprises  the  in- 
vestment banker  plays  no  part.  The  banker  must  have  some 
body  of  evidence  by  which  to  predict  future  earnings  from 
past  actual  experience  before  he  can  risk  his  reputation  by 
recommending  to  his  customers  that  a  given  security  is  even 
relatively  secure. 

51 


52  CORPORATION  FINANCE  [VI 

The  Promoter  and  Inventor. — The  exploitation  of  a  new 
invention  intended  to  meet  a  general  demand — like  a  new 
collar  button,  a  new  hairpin,  or  even  a  new  camera — is  at  best 
a  mere  gamble.  The  psychology  of  the  "people"  is  so  complex 
that  the  value  they  will  place  on  a  new  article  is  absolutely 
unpredictable;  the  public  buys  because  a  new  device  or  a  new 
toy  takes  its  fancy,  whether  it  be  autographic  cameras  or 
automobiles,  and  though  the  successful  promoter  of  such  enter- 
prises gradually  acquires  skill  in  interpreting  the  probable 
market  for  the  article  from  the  first  signs  of  the  public's 
attitude  toward  it,  and  lessens  his  risk  by  testing  out  the  public 
demand  before  he  invests  very  much  in  any  new  enterprise, 
he  will  even  so  have  only  the  most  speculative  securities  to 
offer. 

The  promoter  of  a  new  enterprise  may  be  the  inventor. 
Ordinarily,  however,  he  is  not.  The  inventor  is  usually  a  man 
of  mechanical  skill  and  clever  originality,  but  quite  as  fre- 
quently unaccustomed  to  giving  economic  values  their  full  sig- 
nificance. He  is  what  is  often  called  an  "impractical  genius."  A 
promoter  must  possess  not  only  a  prophetic  insight  but  also 
the  power  of  transforming  a  vision  into  a  definite  instrument 
of  economic  usefulness.  In  other  words,  he  must  possess 
what  might  be  called  "business  imagination"  and  be  a  man  of 
simple  common  sense. 

The  Promotion  of  an  Invention. — When  a  new  invention 
attracts  his  attention  the  first  matter  that  he  must  attend  to  is 
that  of  patents.  No  business  can  be  based  on  an  invention, 
discovery,  or  even  a  "trade-mark,"  unless  it  may  be  protected 
by  the  courts  from  infringements.  Especially  is  this  true  if 
the  invention  pretends  to  cover  some  fundamental  idea  upon 
which  there  can  be  a  variety  of  modifications  and  adaptations 
which  duplicate  the  purpose  of  the  invention  without  infringing 
the  letter.     In  such  cases  a  competitor  may  spring  up,  should 


VI  ]  THE  PROMOTION  OF  NEW  ENTERPRISES  53 

the  new  invention  prove  successful,  and  sell  a  large  quantity 
of  goods  on  the  strength  of  the  advertising  program  paid  for 
by  the  original  company.  At  the  time  of  the  exploitation  of  the 
vacuum  bottle  there  was  no  fundamental  basic  patent,  and  as 
soon  as  one  company  had  made  a  market  for  the  goods,  com- 
petitors sprang  up  who  could  sell  goods  that  were  identical  in 
all  respects  except  name.  As  the  original  company  had  made 
the  mistake  of  fixing  the  retail  prices  too  high,  the  competitors 
secured  a  wide  market  and  liberal  profits  by  selling  what  was 
in  truth  "the  same  thing"  at  a  distinctly  lower  level  of  price. 
After  being  assured  that  the  patents  or  licenses  under  which 
the  invention  is  to  be  sold  constitute  a  substantial  protection 
which  the  courts  will  uphold,  the  next  step  of  the  promoter  is 
to  consider  the  market.  It  may  seem  more  logical  for  the 
promoter  to  determine  first  the  cost  and  probable  selling  price, 
since  the  latter  will  influence  the  demand,  but  in  practice  his 
concern  is  with  the  demand  at  some  approximate  price,  in  order 
that  he  may  decide  whether  or  not  to  proceed  with  a  further 
investigation.  In  case  the  new  product  is  intended  for  general 
consumption  he  has  absolutely  no  test  to  apply  in  regard  to 
the  magnitude  of  the  possible  sales  at  some  assumed  price.  It 
may  "take,"  in  which  case  the  new  product  may  experience 
an  enormous  demand,  quick  but  transient,  or  it  may  meet  a 
steadily  increasing  demand  somewhat  proportionate  to  the 
extent  of  the  advertising.  More  probably — and  this  is  the  fate 
of  the  vast  majority  of  new  inventions  placed  on  the  market 
to  meet  a  popular  demand — there  will  be  a  few  sales  in  response 
to  a  comparatively  large  expenditure  for  advertising,  but  these 
will  cease  entirely  when  the  advertising  ceases.  In  such  case, 
the  new  invention  is,  in  the  plain  language  of  business,  a 
failure. 

Inventions  to  be  Sold  to  Manufacturers. — The  exploitation 
of  patented  articles  that  are  to  be  sold  to  manufacturers  is  not 


54  CORPORATION  FINANCE  [  VI 

quite  as  uncertain  as  that  of  articles  made  expressly  to  satisfy 
a  real  or  anticipated  popular  fancy.  If  the  article  is  intended 
to  meet  a  special  demand,  as  an  automatic  attachment  for  a 
loom  or  a  simplified  high  tension  transformer,  the  task  of 
predicting  the  possible  demand  is  relatively  easy.  The  ultimate 
success  of  the  patented  article  will  rest  very  largely  on  a  careful 
computation  of  the  amount  the  manufacturer  will  save  in  the 
costs  of  production  by  the  introduction  of  the  new  device. 
The  more  progressive  manufacturers  will  adopt  the  improve- 
ment if  there  is  the  slightest  hope  of  decreasing  costs;  others 
will  adopt  it  only  as  a  last  resort  after  its  economy  has  been 
proved  over  and  over  again.  The  vast  majority  of  manu- 
facturers will  occupy  the  middle  ground.  If  the  promoter  has 
a  meritorious  attachment  or  improvement  that  can  be  counted 
upon  to  reduce  the  costs  appreciably,  so  as  to  save  an  amount 
considerably  in  excess  of  the  investment  required  to  install  it, 
he  can  compute  with  a  surprising  degree  of  accuracy  the  upper 
and  the  lower  limits  of  its  demand.  The  success  of  the  com- 
pany promoted  to  sell  the  new  device  will  rest,  then,  on  its 
ability  to  meet  this  demand  at  a  price  that  yields  a  profit. 

Having  estimated,  or  rather  guessed,  the  probable  demand 
for  the  new  article,  the  promoter  will  probably  retrace  his  steps 
and  determine  more  exactly  the  cost  of  manufacture  and  the 
margin  of  profit  at  the  assumed  selling  price  in  order  that  he 
may  correct  the  latter.  In  case  the  article  is  for  general  demand 
the  most  difficult  element  of  the  cost  to  determine  will  be  that 
of  advertising  and  marketing.  For  details  in  this  field  the 
promoter  will  probably  draw  liberally  on  his  own  experience, 
reinforced  by  that  of  advertising  managers  who  give  their 
advice  either  independently  as  "experts,"  or  else  as  employees 
of  advertising  agencies.  If  the  article  is  easily  made,  the 
promoter  will  probably  secure  estimates  for  its  manufacture, 
preferring  not  to  use  the  little  capital  at  his  disposal  in  erecting 
a  plant  for  the  new  company. 


VI]  THE  PROMOTION  OF  NEW  ENTERPRISES  55 

Organization  of  a  Company. — After  he  has  assured  himself 
of  sufficient  information  to  feel  confident  that  the  exploitation 
of  the  invention  will  be  profitable,  the  promoter  must  organize 
a  company  and  secure  the  necessary  capital.  The  organization 
of  such  companies  is  of  the  simplest  sort.  Common  stock  is 
issued ;  some  of  it  is  given  to  the  inventor,  some  to  the  promoter 
and  any  other  active  partners — the  rest  offered  for  sale.  The 
main  point  of  comment  is  on  the  methods  of  sale.  Quite 
generally  the  promoter  will  try  to  interest  some  single  capital- 
ist in  the  invention,  who  will  supply  the  money  necessary  to 
start  the  company;  less  often  the  stock  will  be  offered  to  the 
public.  In  the  latter  case,  the  invention  is  probably  of  little 
value,  as  a  promoter  will  find  no  difficulty  in  securing  private 
capital  if  the  invention  promises  to  be  of  merit. 

Sale  of  Stock  by  the  Corporation. — The  methods  used  in 
drawing  capital  from  the  general  public  for  these  most  specu- 
lative enterprises  are,  however,  interesting  of  themselves. 
There  are  various  devices  used.  The  company  may  assign  a 
certain  number  of  shares  to  its  own  treasury  and  then  announce 
a  sale  of  "treasury  stock."  The  risk  of  sale  and  the  expense  of 
newspaper  advertising  and  distributing  circulars  are  borne  by 
the  corporation  itself.  Unfortunately  this  straightforward 
method  of  selling  securities  is  not  in  good  repute.  Investors 
have  a  natural  suspicion  of  a  company  which  not  only  attempts 
to  conduct  its  own  business,  but  which  also  tries  to  solicit  the 
investment  of  capital;  and  this  feeling  has  l^een  intensified 
into  a  well-founded  prejudice  by  the  fact  that  fraudulent 
mining,  oil,  rubber,  and  real  estate  companies  have  followed 
this  practice.  To  avoid  this  prejudice,  corporations  wishing  to 
sell  their  own  stock  have  adopted  one  of  two  other  methods. 

Some  director,  officer,  or  other  person  closely  connected 
with  the  embryo  company,  serves  as  its  "fiscal  agent."  The 
advertisements  in  which  the  securities  are  offered  to  the  public 


56  CORPORATION  FINANCE  I VI 

seek  to  represent  the  fiscal  agent  as  an  independent  banker,  and 
not  a  mere  representative  or  employee  of  the  company  and  its 
promoters.  Furthermore,  the  announcements  are  usually  so 
worded  that  a  reader  would  be  led  to  believe  that  the  statements 
contained  are  made  on  the  responsibility  of  the  fiscal  agent 
rather  than  on  that  of  the  company's  promoters  or  officers. 
This  is  done  in  order  to  give  the  impression  that  an  outside 
person  has  assumed  the  independent  responsibility  properly 
belonging  to  a  banker,  and  upon  that  responsibility  is  offering 
the  securities  to  the  public.  The  other  subterfuge  adopted  to 
enable  a  prospective  corporation  to  sell  its  own  securities  with- 
out appearing  to  do  so  is  to  cause  a  subsidiary  company  to  be  in- 
corporated, the  character  of  which  permits  it  to  deal  in  stock  or 
other  securities.  In  practice  the  operation  of  this  fictitious  cor- 
poration is  identical  with  that  of  the  tactics  of  the  fiscal  agent. 

Sales  Through  Fictitious  "Banking  Houses." — Often  men 
of  thoroughly  honest  intention,  with  a  burning  enthusiasm  for 
their  invention  or  their  discovery,  finding  a  cold  reception  from 
bankers,  drift  into  the  hands  of  swindlers  who  exploit  the 
simple-minded  and  honest  inventor  for  their  own  profit. 
There  exist  so-called  banking  houses  with  fictitious  names,  in- 
vestment companies,  incorporated  fiscal  agents,  and  the  like, 
who  stand  ready  to  distribute  worthless  securities  at  an  ex- 
orbitant commission,  and  the  fact  that  the  enterprise  has  to 
some  extent  an  economic  basis  often  gives  the  advertising 
material  distributed  by  these  fictitious  "banking  houses"  or 
"investment  bankers"  a  very  plausible  ring,  whereas  the  truth 
of  the  matter  is  that  the  risks  of  the  enterprise,  whether  they 
are  legitimate  or  illegitimate,  are  so  great  that  no  reputable 
bankers  will  jeopardize  their  business  standing  by  backing  it. 
There  is  usually  some  clever  writer  in  the  organization  who 
acquires  a  devilish  skill  in  preparing  circular  advertising  matter 
well  suited  to  deceive  the  credulous  public ;  and   the   fraud 


VI]  THE  PROMOTION  OF  NEW  ENTERPRISES  57 

perpetrated  by  these  fictitious  investment  bankers  is  often  more 
artistically  executed  than  is  the  case  when  the  corporation,  or 
its  promoters,  seeks  to  distribute  the  securities  by  one  of  the 
more  direct  methods  heretofore  described.  The  commissions 
exacted  by  such  swindlers  are  usually  enormous,  representing 
the  major  part  of  what  the  public  pays  for  the  securities.  For 
instance,  the  Sterling  Debenture  Corporation,  engaged  in  the 
distribution  of  low-grade  securities,  sold  the  stock  of  a  certain 
electrical  device  for  $io  a  share.  Its  commission  amounted  to 
$9  a  share. 

Appeals  to  Desire  for  High  Return. — Various  devices  are 
used  by  the  distributors  of  speculative  or  fraudulent  securities. 
The  most  forceful  appeals  are  to  the  desire  for  high  return 
and  to  the  speculative  instinct,  on  the  part  of  the  possible 
investor.  The  latter  is  directly  or  indirectly  promised  a  rate 
of  return  on  his  prospective  investment  far  above  that 
ordinarily  expected  from  a  conservative  or  even  somewhat 
speculative  security.  The  glamour  of  the  increased  income 
overrules  his  sound  business  judgment.  He  is  told  that,  "the 
increased  cost  of  living  has  made  it  necessary  for  the  corpora- 
tion to  pay  a  liberal  amount  for  its  money,"  as  if  the  company 
were  engaged  in  a  philanthropic  calling,  one  of  the  purposes 
of  which  was  to  alleviate  the  distress  caused  by  rising  prices. 
Another  excuse  is  the  economy  of  distribution  obtained  through 
selling  the  securities  directly  to  the  public.  "Co-operation 
between  producers,  distributors,  and  investors  will  result  in 
saving  of  expense  and  v*^aste  sufficient  to  divide  large  profits 
with  all,"  or  "Every  time  you  buy  stock  from  a  salesman  or 
broker,  you  are  paying  a  premium  of  20  to  25  per  cent,  which 
is  unnecessary  waste,  and  would  be  a  good  dividend  for  two 
years  on  the  money  which  goes  into  the  company's  treasury." 
Often  in  order  to  strengthen  his  position,  the  writer  of  such 
advertising  bulletins  casts  reflections  upon  "Wall  Street"  and 


58  CORPORATION  FINANCE  [VI 

the  "avaricious  horde  of  robbers  who  infest  our  financial  dis- 
tricts," in  order  to  show  by  contrast  his  scrupulous  honesty 
and  liberality  to  prospective  investors.  And  the  small  investors, 
who  have  probably  worked  very  hard  for  their  savings,  feel 
that  the  great  sacrifice  represented  by  their  small  accumula- 
tions somehow  entitles  them  to  a  higher  return  than  meager 
interest  rates  paid  by  savings  banks  or  on  investment  bonds. 
They  are  easily  deluded  into  thinking  there  is  some  connection 
between  the  psychological  sacrifice  of  saving  and  the  economic 
compensation  for  the  saving,  and  forget  that  fluid  capital  in 
the  form  of  money,  unlike  labor  or  business  ability  or  land,  is 
of  one  and  the  same  nature,  whatever  its  origin,  whether 
laboriously  saved  by  the  clerk  or  merely  "set  aside  for  invest- 
ment" by  the  capitalist. 

Appeals  to  Speculative  Instinct. — The  speculative  instinct 
of  man  combines  at  least  three  psychological  elements,  present 
in  greater  or  lesser  degree  in  us  all.  The  first  is  the  desire 
for  accumulation,  the  fundamental  instinct  for  possession.  The 
second  is  a  kind  of  self-conceit,  the  feeling  that  somehow  we, 
individually,  are  cunning  enough  to  anticipate  and  profit 
through  the  future.  It  is  a  kind  of  self-assurance,  the  amour 
propre  of  Rochefoucauld.  The  third  is  the  natural  inclina- 
tion to  get  something  for  nothing,  the  temptation  to  take  a 
crosscut,  the  same  characteristic  which  is  so  important  a 
stimulus  to  labor-saving  invention,  and,  broadly,  one  of  the 
underlying  motives  in  the  technical  progress  of  the  race.  Those 
who  seek  to  defraud  the  small  investor  through  the  sale  of 
worthless  securities  understand  well  the  full  significance  of  the 
speculative  instinct,  and  these  three  roots.  One  of  their 
devices  is  to  claim  that  the  stock  should  be  bought  while  the 
company  is  just  starting,  as  an  advance  in  the  price  of  the 
stock  will  soon  occur.  "It  is  very  much  to  your  interest  to 
join  me  now.     In  the  oil  business,  fortunes  are  made  over- 


VI  ]  THE  PROMOTION  OF  NEW  ENTERPRISES  59 

night  and  the  small  investor  of  today  is  the  millionaire  of 
tomorrow.  Stock  of  a  company  operating  near  us  in  Texas 
recently  rose  from  $io  per  share  to  $20  per  share,  practically 
overnight.  Act  today!"  And  most  appealing  is  the  descrip- 
tion, carefully  worded,  of  other  marvelously  successful  com- 
panies whose  stock  might  have  been  purchased  by  the  small 
investor  during  the  promotion  period.  If  it  is  an  oil  well, 
stories  of  clerks,  postmasters,  day  laborers,  who  purchased 
shares  of  some  "bonanza"  oil  company  are  told  in  dramatic 
fashion.  All  such  anecdotes — some  of  them  doubtless  true — 
are  closed  by  the  significant  words:  "If  you  want  to  share 
in  the  marvelous  profits  of   the   oil   industry,   then   buy  the 

treasury  stock  of    immediately.     Don't  wait." 

Often  such  a  direct  command  is  followed  by  another  equally 
dramatic,  but  pathetic,  anecdote  of  some  man  who  was  olTered 
a  bonanza  stock  but  followed  his  wife's  advice  and  put  the 
money  in  the  savings  bank  or  a  parlor  rug ! 

The  imagination  of  the  promoters  does  not  always  confine 
itself  to  the  particular  industry  in  which  the  new  company 
is  engaged.  Any  other  successful,  well-known  enterprise  will 
answer  the  purpose.  Copper  mines  and  sewing  machine  com- 
panies are  given  as  reasons  for  investing  in  oil  companies  and 
rubber  plantations ! 

Appeal  to  the  Investor's  Vanity. — In  addition  to  the  appeal 
to  the  investor's  avarice  and  speculative  propensity,  some 
shrewd  promoters  have  recently  made  a  direct  appeal  to  the 
investor's  vanity.  This  appeal  is  not  so  potent  as  the  appeal 
to  the  investor's  avarice,  but  it  is  certainly  more  original  and 
can  be  made  more  dramatic.  It  is  especially  significant  with 
prospective  women  investors.  Sometimes  the  promoter  plays 
on  the  investor's  social  or  professional  standing,  as  when  the 
stock  is  offered  to  a  "selected  list  of  teachers,  of  which  you 
are  one" ;  or  when  "it  is  the  desire  of  the  directors  to  dispose 


6o  CORPORATION  FINANCE  [  VI 

of  the  first  block  of  treasury  stock  to  men  and  women  promi- 
nent in  social  life.  You  are  urged  not  to  lose  this  privilege 
of  securing  a  permanent  income.  Please  fill  out  accompanying 
blank,  which  is  for  your  own  personal  use,  and  is  not  trans- 
ferable." Sometimes  it  plays  on  the  prospective  investor's 
high  opinion  of  his  own  ability,  as  when  the  prospectus  states, 
"You  are  selected  from  a  large  group  because  of  your  known 
skill  in  choosing  conservative,  yet  profitable  investments.  The 
privilege  of  subscribing  has  been  limited  to  the  leading  persons 
from  your  state.  Unless  you  reply  within  thirty  days  this 
privilege  will  be  withdrawn,  and  will  go  to  someone  else." 

"Sucker  Lists." — There  are,  indeed,  men  and  bureaus 
which  collect  names  of  men  and  women  who,  for  one  reason  or 
another,  may  be  presumed  to  be  susceptible  to  the  elusive 
advertising  matter  distributed  by  the  promoters  of  highly 
speculative  and  worthless  securities.  Two  main  sources  supply 
the  names :  men  or  women  who  at  one  time  or  another  have 
bought  such  stocks,  and  men  and  women  in  the  various  pro- 
fessions. To  get  the  former,  the  stockholders'  lists  of  defunct 
and  low-grade  companies  are  ransacked.  Once  a  woman  buys 
a  few  shares  of  a  mine  or  oil  well,  her  name  gets  on  one  of 
these  "sucker  lists"  and  she  is  pestered  for  years  after  by 
advertising  matter  of  this  kind.  The  other,  source  is  the 
published  lists  of  the  professions  and  to  some  extent  well-to-do 
farmers  and  highly  paid  artisans.  The  physicians,  teachers, 
dentists,  and  clergymen  constitute  a  happy  hunting  ground  for 
these  economic  pirates.  Women  school  teachers  afford  perhaps 
the  most  fertile  field ;  as  a  class  they  know  nothing  about 
business  or  investment;  they  usually  earn  a  little  more  than 
they  spend ;  they  are  much  concerned  with  laying  aside  a  com- 
petence for  their  old  age,  are  credulous,  and  easily  deceived  by 
men  familiar  with  business,  and  are  accustomed  by  long  habit 
to  making  decisions  on  practical  matters  without  consulting 


VI]  THE  PROMOTION  OF  NEW  ENTERPRISES  6 1 

Other  people.  Often  teachers  and  clergymen  are  seduced  by 
some  wily  promoter  into  turning  salesmen  for  a  fraudulent 
security,  thinking  the  enterprise  sound  and  honestly  managed. 
Acting  under  this  delusion  they  persuade  relatives,  friends,  and 
associates  to  buy  worthless  stocks. 

Proper  Backing  of  Speculative  Enterprises. — Practically 
all  industries  at  their  very  beginning,  and  many  industries, 
such  as  mining  and  oil  drilling,  under  all  circumstances,  are 
unable  to  obtain  capital  through  the  investment  banker.  Thus 
the  question  naturally  arises  as  to  the  proper  means  of  selling 
securities  of  highly  speculative  enterprises  if  successful  direct 
selling  requires  the  use  of  methods  now  frowned  upon  because 
used  by  swindlers.  One  observation  is  surely  true.  The 
highly  speculative  enterprise  should  not  be  backed  by  the 
general  public.  It  requires  too  much  investigation  and  dis- 
crimination. The  chances  of  loss  are  too  great.  For  this 
reason  the  stock  of  a  highly  speculative  enterprise,  no  matter 
how  meritorious  in  itself,  should  not  be  advertised  for  in- 
discriminate investment.  It  should  be  backed  in  the  earlv 
stages  by  a  man  or  group  of  men  of  wealth  (by  friends,  per- 
haps, as  in  the  case  of  Bell  and  the  telephone),  who  have  the 
time  for  a  careful  and  exhaustive  investigation  and  who,  should 
their  investment  prove  a  loss — as  it  probably  will  even  after 
the  most  painstaking  investigation — are  able  to  stand  the 
sacrifice.  But  to  take  the  savings  of  hard-working  men  and 
women  to  develop  a  speculative  undertaking,  no  matter  how 
meritorious  in  itself  and  honestly  managed,  is  little  short  of  a 
social  crime. 


CHAPTER  VII 

THE  PROMOTION  OF  NEW  COMPANIES  IN 
ESTABLISHED  FIELDS 

The  Promoter  in  Established  Industries. — The  work  of  the 
promoter  in  starting  a  new  manufacturing  estabhshment  in  an 
industry  already  well  known  differs  considerably  from  that  of 
initiating  an  entirely  new  industry  on  the  one  hand  and  that 
of  organizing  a  public  service  enterprise  on  the  other.  The 
promoter  of  a  new  factory  is  almost  invariably  a  manu- 
facturer previously  successful  in  the  same  line  of  work. 
Frequently  he  has  promoted  other  successful  factories  and  has 
thus  secured  the  confidence  of  capitalists  as  well  as  of  the 
public.  Sometimes  he  is  himself  without  means,  but  has  risen 
to  the  position  of  superintendent  or  sales  manager  of  a  large 
establishment  and  seeks  to  start  a  small  factory  of  his  own. 
In  such  cases  local  merchants,  bankers,  and  even  the  public, 
will  enter  the  new  enterprise  with  him,  because  of  his  proved 
ability  and  familiarity  with  the  business.  If  the  town  in  which 
the  promoter  lives  is  devoted  to  one  industry,  he  may  have 
gained  a  reputation  for  skill  of  management  and  even  be 
solicited  by  local  capitalists  to  "build  a  mill  of  his  own."  In  all 
such  cases  the  promoter  succeeds  by  his  familiarity  with  the 
business  rather  than  through  any  foresight  or  skill  in  inter- 
preting economic  needs.  For  that  reason  his  is  not  a  typical 
promotion  and  he  does  not  make  the  promoter's  characteristic 
contribution  to  our  industrial  development.  The  promoter  of 
an  enterprise  of  this  type  can  almost  assuredly  count  on  the 
help  of  some  investment  banker  in  selling  such  securities  as  are 
to  be  publicly  sold.  This  banker  will  probably,  with  or  without 
the  aid  of  the  promoter,  formulate  the  financial  plan  according 

62 


VII]  NEW  COMPANIES  IN  ESTABLISHED  FIELDS  63 

to  which  bonds  and  stocks  are  issued.  He  will  supervise  the 
organization  and  he  may  audit  the  construction  accounts  in 
case  considerable  amounts  of  money  are  to  be  spent 
immediately. 

Formulating  the  Financial  Plan. — The  financial  plan  of  a 
new  manufacturing  enterprise  is  ordinarily  simple  in  general 
outlines,  in  that  it  involves  few  kinds  of  securities,  but  there 
are  many  considerations  which  make  its  formulation  extremely 
difficult.  Foremost  of  these  is  the  great  uncertainty  of  the 
earning  capacity  of  the  new  company.  This  of  itself  makes  it 
unwise  to  issue  bonds  and  limits  the  securities  to  common  and 
preferred  stock.  The  question  of  how  the  group  concerned  in 
promoting  the  enterprise  can  keep  the  control  in  their  own 
hands  also  rises,  for  usually  preferred  stock  as  well  as  common 
stock  is  given  voting  power. 

Estimate  of  Probable  Earnings. — It  is  necessary,  also,  to 
make  as  accurate  an  estimate  of  future  earnings  as  possible 
before  determining  the  amount  and  dividend  rate  of  any  pre- 
ferred stock,  for  the  credit  of  a  company  is  badly  affected  if 
the  payment  of  the  dividend  on  the  preferred  stock  is  irregular. 
If  possible  this  estimate  of  future  earnings  will  be  based  on  the 
earnings  of  some  other  concern  doing  the  same  or  a  very 
similar  business  but  such  comparisons  with  established  com- 
panies should  be  made  only  in  industries  operating  under 
conditions  which  afford  ideally  free  competition,  where  good- 
will patent  rights,  or  other  intangible  elements  are  not  of 
substantial  consequence.  These  include  relatively  small  busi- 
nesses easily  undertaken  by  men  of  average  ability,  businesses 
in  which  no  patented  processes  or  machines  are  required,  or, 
if  required  for  economical  operation,  may  be  licensed  or 
purchased  by  anyone.  Furthermore  the  business  should  be 
one  which  produces  a  stable  commodity  sold  in  such  form  that 


64  CORPORATION  FINANCE  [  VII 

the  identity  of  the  producer  is  of  no  concern  to  the  ultimate 
consumer.  Any  business  complying  with  these  conditions  will 
yield  a  rate  of  return  determined  by  the  average  rate  of  interest 
on  the  capital  investment  and  the  relative  skill  of  management 
exercised  by  the  men  in  control. 

The  Management  Factor. — The  reason  for  the  difficulty 
in  estimating  profits  is  that  they  are  so  enormously  dependent 
upon  that  particularly  variable  element,  the  skill  of  manage- 
ment. Estimates  of  earning  capacity  even  where  based  on  the 
earnings  of  similar  businesses  must  therefore  be  adjusted  on 
the  basis  of  at  least  one  element  which  is  unknown  and  which 
is  more  important  than  all  others.  If  the  man  who  is  to 
undertake  the  management  has  been  successful  elsewhere  under 
similar  conditions,  there  is  less  uncertainty.  But  even  then 
there  may  be  present  some  small  but  not  insignificant  element 
which  renders  a  seemingly  parallel  or  identical  case  unsuitable 
for  comparison. 

This  is  particularly  true  when  a  successful  manager  of  a 
small  plant  assumes  control  of  a  much  larger  plant.  Twice  in 
the  history  of  the  New  England  Cotton  Yarn  Company  the 
men  in  control  of  the  company  made  the  fatal  error  of  infer- 
ring that  a  man  who  had  been  successful  in  running  a  single 
mill  could  be  equally  successful  in  the  management  of  a  group 
of  mills.  In  both  cases  heavy  losses  followed,  leading  to 
forced  reorganizations.  A  certain  enterprise  has  six  factories 
in  the  Middle  West.  To  gain  efficiency  it  built  at  a  cost  of 
$10,000,000  a  thoroughly  modern  mill,  the  largest  of  the  kind 
in  existence.  The  directors  selected  as  manager  the  man  who 
had  been  the  most  successful  in  the  operation  of  the  smah 
factories.  He  made  a  failure  of  the  large  one.  Ultimately  its 
management  was  given  to  a  man  who  had  shown  less  than 
ordinary  ability  in  the  management  of  a  small  unit.  His 
administration  was  successful. 


VII  ]  NEW  COMPANIES  IN  ESTABLISHED  FIELDS  65 

"Dead  Reckoning." — When  a  manufacturing  business  is 
started  in  a  new  geographically  locality  a  process  of  "dead  reck- 
oning" is  often  used  in  the  effort  to  predict  future  earnings. 
For  example,  the  superintendent  of  a  St.  Louis  shoe  factory 
happens  to  be  visiting  in  Dallas,  Texas,  and  finds  that  large 
quantities  of  shoes  are  imported  from  St.  Louis  and  even  from 
Lynn  and  Brockton.  He  seeks  to  interest  local  capitalists  in 
the  erection  of  a  modern  shoe  factory,  the  administration  of 
which  he  will  control.  In  order  to  prove  to  the  local  bankers 
that  the  factory  would  pay,  he  will  probably  obtain  more  or 
less  reliable  estimates  of  the  profits  of  the  St.  Louis  shoe- 
makers to  prove  that  the  industry  is,  in  itself,  profitable.  He 
will  then  gather  statistics  covering  the  sale  of  shoes  in  the 
jobbing  district  of  which  Dallas  is  the  center  and  at  the  same 
time  compute  the  cost  per  pair  for  labor  and  raw  materials 
at  Dallas.  In  all  such  cases,  no  matter  how  accurate  the 
statistical  computations,  there  are  many  unknown  factors  which 
will  modify  the  final  outcome,  not  the  least  of  which  will  be 
the  superintendent's  lack  of  experience  in  selling  shoes  in 
Texas.  A  study  of  what  other  people  are  doing  in  any  line 
of  business  should  not  for  a  moment  be  considered  as  an 
accurate  indication  of  what  a  new  man  can  do  under  new 
conditions,  however  close  the  parallel  may  seem. 

Investment  Traditions  and  Prejudices. — In  general,  two 
considerations  influence  promoters  and  bankers  in  plotting  the 
financial  plan  of  a  new  manufacturing  company.  These  two 
major  considerations  are  the  estimated  earnings — regarding 
which,  as  has  been  indicated,  little  can  be  said  with  definite- 
ness — and  the  general  traditions  and  prejudices  of  the  investors 
to  whom  the  securities  are  to  be  sold.  This  is  much  less  a 
matter  of  surmise  than  the  probable  earnings,  although  it  is 
of  less  permanent  significance  to  the  company  itself.  Invest- 
ment is  a  matter  of  fashion.     Customs  established  and  pre- 


66  CORPORATION  FINANCE  [VIl 

judices  deep-grounded  in  the  minds  of  investors  cannot  be 
changed  easily;  the  promoter  must  observe  them  whether 
he  would  or  not.  This  is  excellently  illustrated  by  the  current 
and  accepted  custom  that  bonds  should  not  be  used  in  the 
financial  plan  of  a  manufacturing  enterprise.  Historically  it  is 
explained  by  the  fact  that  manufacturers  and  bankers  in  New 
England,  where  most  of  our  manufacturing  industries  origi- 
nated and  where  many  of  them  are  even  now  located,  are 
traditionally  opposed  to  creating  a  direct  funded  debt  on  a 
manufacturing  plant.  This  old  tradition  has  been  strengthened 
by  two  very  important  considerations.  Bonds  are  taxable 
in  several  New  England  states,  whereas  stocks  are  not.  Added 
to  this  is  the  very  important  fact  that  banks  are  more  will- 
ing to  loan  money  on  the  general  credit  of  a  manufacturing 
company  with  liberal  net  quick  assets  if  it  has  no  bonded  debt 
on  its  plant.  While  the  tradition  against  bonds  is  stronger  in 
New  England  than  elsewhere,  it  is  nevertheless  true  that  the 
financial  plan  of  every  manufacturing  enterprise  must  give  at 
least  some  weight  to  it. 

Stock  Issues  Against  Mere  Prospective  Profits. — The 
principles  stated  above  must  be  applied  differently  according  to 
the  nature  of  the  manufacturing  business  for  which  the  pro- 
moter or  banker  is  formulating  the  financial  plan.  In  the  case 
of  a  specialty  manufacturing  business  and  similar  speculative 
enterprises,  only  one  class  of  stock  should  be  issued.  The 
whole  future  earning  capacity  of  the  enterprise  is  so  doubtful 
that  no  investor  can  be  expected  to  consider  a  preferred  stock 
any  more  secure  than  the  common  stock,  and  all  will  prefer  the 
latter  because  it  will  carry  greater  opportunities  for  speculative 
profit.  Needless  to  say,  the  bonds  of  such  an  enterprise  will 
be  practically  unsalable,  except  at  rates  of  discount.  If  sold, 
the  proceeds  would  yield  the  new  company  no  more  money 
than  the  sale  of  the  same  amount  of  common  stock.    The  rule 


VII  ]  NEW  COMPANIES  IN  ESTABLISHED  FIELDS  67 

for  the  financial  plan  in  such  cases  is  simple — only  common 
stock  should  be  issued  against  mere  prospective  profits.  And 
as  human  nature,  especially  that  of  credulous  people,  draws 
some  connection  between  the  par  value  on  the  face  of  the 
certificate  and  the  actual  value,  promoters  and  bankers  usually 
issue  stock  in  amounts  far  exceeding  what  any  reasonable  ex- 
pectations of  profits  would  warrant.  In  order  to  keep  the 
control  of  the  management  of  the  company  still  in  their  own 
hands,  they  issue  to  themselves  such  large  amounts  of  the 
stock  in  return  for  patent  rights  and  banking  services  that 
their  proportion  will  exceed  that  sold  to  the  public. 

Stock  Issues  Against  Estimated  Earnings. — If  some 
special  condition  of  the  business  makes  it  possible  to  reach  some 
plausible  estimate  of  earnings  on  the  basis  of  the  previous 
earnings  of  the  plants  or  of  the  nature  of  the  industry,  a 
preferred  stock  may  be  issued  to  be  sold  to  a  group  of  men 
sometimes  called  "speculative  investors."  Yet  even  those  cases 
in  which  the  industry  conforms  to  the  theoretical  conditions 
where  prophecy  of  earnings  would  seem  to  be  most  reliable  are 
subject  to  individual  uncertainties.  Changes  in  the  cost  of  raw 
materials  and  in  the  rates  of  interest  and  of  wages  render  any 
particular  estimate  of  the  future  earnings  little  better  than  an 
intelligent  guess;  and  at  the  time  of  promotion,  before  the 
efficiency  of  the  new  management  under  new  conditions  has 
been  tried  out,  preferred  stocks  even  in  an  established  and  stable 
industry  must  be  considered  highly  speculative.  When  there 
are  two  classes  of  stock  issued  in  the  first  instance,  most 
or  perhaps  all  of  the  common  stock  will  be  used  in  payment 
for  services  at  the  time  of  promotion;  it  will  be  given  to  the 
promoter,  the  banker,  attorneys,  engineers,  and  general  utility 
men.  In  case  old  plants  are  taken  over  into  a  new  combination, 
stock  in  the  new  company  may  be  used  in  place  of  purchase 
money. 


68  CORPORATION  FINANCE  [VII 

The  Promoter's  and  the  Banker's  Profits. — The  exact  pro- 
portion of  common  shares  that  shall  go  to  the  promoter  is  al- 
ways the  subject  of  considerable  negotiation.  Invariably  th'C 
banker  takes  the  lion's  share,  under  the  supposition  that  the 
risks  of  furnishing  capital  are  greater  than  those  of  furnishing 
imagination  and  enthusiasm,  presuming  that  the  evil  conse- 
quences to  a  banker's  reputation  likely  to  follow  from  the 
failure  of  an  enterprise  are  more  lasting  and  more  serious  than 
in  the  case  of  the  promoter.  Custom  seems  to  have  decreed 
that  about  lo  per  cent  of  the  common  stock  is  a  fair  compensa- 
tion to  the  promoter,  but  this  may  be  increased  very  much  if 
the  promoter  assumes  larger  functions  than  those  of  merely 
conceiving  the  enterprise.  Where  he  combines  the  functions 
of  inventor,  promoter,  and  banker  he  may  even  take  51  per  cent 
of  the  entire  capitalization  as  his  compensation. 

The  rate  of  commission  for  selling  stocks  is  higher  than 
that  for  selling  bonds — varying,  too,  as  the  indorsement  of  the 
company  carries  with  it  risk  or  prestige.  For  industrials  such 
as  we  are  now  considering  it  is  highest — leaving  out  of  account 
the  wholly  speculative  securities  considered  in  the  last  chapter. 
For  any  given  grade  of  security  it  is  remarkably  uniform 
among  the  different  dealers.  Out  of  15  cases  of  initial  issues 
of  local  industrial  preferred  stocks  the  average  commission  was 
found  to  be  14%  per  cent — about  3  per  cent  of  this  was  prob- 
ably absorbed  in  selling  expenses.  Besides  his  commission  for 
selling  the  securities,  the  banker  may  be  given  also  a  bonus  of 
common  stock  for  his  services.  High  commissions  or  long 
profits  tend  to  make  preferred  stocks  very  popular  with  the 
salesmen  of  banking  houses  and  their  high  rate  of  income  yield 
makes  them  popular  with  a  certain  class  of  security-purchasers ; 
but  the  apparent  high  return  is  not  real  in  either  case.  The 
investment  banker  will  need  to  protect  his  reputation  by  buying 
back  the  securities  he  sells  at  only  a  few  points  under  the  selling 
price,  even  if  the  company  proves  to  be  less  successful  than  it 


VII  ]  NEW  COMPANIES  IN  ESTABLISHED  FIELDS  69 

had  been  before,  and  in  the  long  run  this  will  reduce  consider- 
ably his  total  profits  on  preferred  stocks. 

Underwriting  Syndicates. — In  any  case  unless  the  issue 
is  very  small  the  investment  banker  will  not  attempt  to  handle 
all  the  issue  himself.  He  will  make  arrangements  with  other 
bankers  to  "take  over"  certain  proportions  of  each  issue,  stipu- 
lating in  the  agreement  not  only  the  price  which  the  fellow- 
banker  will  pay  for  his  share  but  also  the  price  for  which  the 
latter  is  to  dispose  of  it  to  his  customers.  This  fellow-banker 
will  also  probably  expect  to  "support  the  market,"  in  case  any 
of  his  customers  may  wish  to  sell. 

In  the  small  local  investment  banking  houses  one  or  two 
men  both  select  and  sell  the  securities,  but  such  small  concerns 
would  seldom  if  ever  have  facilities  for  promoting  new  enter- 
prises. They  deal  in  the  securities  of  established  concerns, 
which  are  handled  much  as  any  other  merchandise  and  with 
a  very  low  commission,  or  in  speculative  securities,  in  neither 
of  which  cases  is  there  any  implied  guaranty  of  supporting  the 
market. 

Organization  of  Large  Distributing  Houses. — The  invest- 
ment banker  most  often  appealed  to  to  act  as  sponsor  of  a  new 
enterprise  is  the  large  distributing  house.  Its  business  is 
ordinarily  chiefly  with  bonds,  but  the  methods  of  selling  are  the 
same  and  will  be  put  into  play  once  the  details  of  a  purchase  or 
underwriting  of  stock  has  been  arranged  by  the  buying  depart- 
ment. The  selling  department  is  the  larger  department  of  the 
business  and  the  one  with  which  the  public  comes  most  in  con- 
tact. The  entire  selling  organization  is  under  immediate  charge 
of  a  general  sales  manager  who  controls  the  selling  organiza- 
tion as  well  as  all  the  branch  offices.  While  the  sales  manager 
may  now  and  then  conduct  a  general  newspaper  advertising 
campaign,  his  chief  reliance  is  upon  the  representatives  of  the 


70  CORPORATION  FINANCE  [  VII 

house  who  personally  visit  the  investors.  The  retail  selling  of 
securities  rests  more  on  the  personal  solicitation  of  salesmen 
than  does  the  retail  distribution  of  any  other  form  of  property. 
A  retail  banking  house  is  an  organization  of  men.  In  addition 
to  the  home  office,  there  are  salesmen  who  travel  over  the 
territory  immediately  adjacent,  and  representatives  of  the  bank- 
ing house  who  range  over  all  the  important  bond-buying  dis- 
tricts. These  men  have  their  headquarters,  consisting  possibly 
of  a  little  ofifice  or  a  hotel  room,  in  the  largest  city  of  the 
district  which  they  cover.  They  are  given  exclusive  privileges 
in  their  localities  and  any  inquiries  made  at  the  home  office  are 
referred  to  the  representatives. 

Training  Bond  Salesmen. — In  the  larger  bond  houses 
there  is  a  regular  system  used  in  procuring,  training,  and  pay- 
ing the  representatives.  As  the  customers  are  probably  men  of 
considerable  education,  great  care  must  be  taken  in  the  selec- 
tion of  the  salesmen-apprentices.  They  are  usually  young 
college  graduates,  chosen  more  often  because  of  the  social 
position  and  standing  of  their  families  than  because  of  any 
other  reason,  but  to  succeed  they  must  possess  an  attractive 
personality,  great  patience,  cheerfulness,  and  a  natural  willing- 
ness to  take  trouble  for  other  people.  They  must  be  true 
salesmen  in  the  best  sense  of  the  word.  Yet  they  need  know 
nothing  about  the  business,  and  can  make  a  modicum  of 
success  without  ever  learning  much  about  finance,  or  even 
appreciating  the  science  of  investment.  A  certain  stock  sales- 
man of  a  small  eastern  banking  house  has  succeeded  solely 
because  of  his  wonderful  good  nature,  his  natural  kindliness, 
his  abounding  good  health,  and  a  clean,  handsome  face.  He 
is  always  welcome ;  people  are  glad  of  his  mere  presence.  Con- 
sequently he  sells  securities,  although  he  knows  nothing  about 
them.    He  smiles,  and  lets  the  customer  do  the  talking. 

During  the  first  year  of  their  apprenticeship  the  salesmen 


VII 1  NEW  COMPANIES  IN  ESTABLISHED  FIELDS  71 

are  paid  $3  a  week,  or  even  nothing  at  all.  These  apprentices 
are  at  constant  attendance  at  the  home  office  "learning  the 
business."  But  practically  no  work  is  expected  of  tiiem,  except 
that  they  may  be  sent  on  errands.  At  the  end  of  their  ap- 
prenticeship these  men  are  given  an  opportunity  of  meeting  a 
few  customers.  Usually  they  are  asked  to  call  on  their  friends 
and  relatives  first.  Subsequently  they  will  be  tried  out  among 
strangers.  If  they  show  an  aptitude  they  will  be  advanced  to 
regular  positions  in  the  home  office  or  else  given  territory  of 
their  own  as  district  representatives  of  the  house.  Later  if 
they  exhibit  marked  success  they  may  be  given  small  participat- 
ing partnerships  in  the  bond  house.  This  has  proved  a  strong 
inducement  to  hold  the  loyalty  of  especially  able  salesmen  to 
the  large  banking  houses  at  lower  salaries  than  they  could 
rightly  anticipate  from  competing  but  smaller  houses. 

Lists  of  Possible  Customers. — Each  investment  house 
keeps  an  exhaustive  list  of  possible  customers.  Indeed  it  has 
been  said  that  every  eastern  bond  house  has,  or  ought  to  have, 
a  list  of  at  least  70  per  cent  of  all  the  bond-buyers  of  conse- 
quence in  every  city  or  town  in  New  England.  This  list  is  car- 
ried on  cards  on  which  also  are  noted  the  peculiarities  of  the 
investor,  his  investment  prejudices,  and — if  possible — a  list  of 
his  investment  holdings.  These  cards  are  kept  constantly  up 
to  date,  through  the  information  obtained  during  the  personal 
calls  of  the  various  representatives.  In  any  town  it  is  presumed 
that  the  bank  directors,  savings  bank  trustees,  successful  and 
middle-aged  physicians  and  dentists,  architects,  and  perhaps 
lawyers,  are  bond-buyers.  The  names  of  such  are  taken  from 
local  sources  and  visited  by  the  representative.  The  method  of 
one  successful  salesman  when  he  went  into  a  town  for  the 
first  time  was  to  find  out  from  the  hotelkeeper  who  it  was 
that  knew  "all  about  the  folks  in  the  town."  Sometimes  it  was 
the  hotelkeeper,   sometimes   an   old   woman.      He   made   the 


72  CORPORATION  FINANCE  [VII 

acquaintance  of  this  person  who,  after  a  few  days  of  careful 
cultivating,  developed  into  an  intimate  acquaintance.  From 
him  or  her  he  gradually  evolved  the  past  history,  financial 
retrospect  and  prospect,  the  weaknesses,  scandals,  feuds,  and 
the  like  of  some  score  or  more  of  the  town's  leading  citizens. 
He  catalogued  all  this  information  on  cards.  On  his  first  visit 
to  a  prospective  customer  he  merely  talked  on  subjects  he  was 
interested  in — or  rather  allowed  the  "prospect"  to  talk.  He 
did  not  try  to  sell  securities  until  his  second  or  third  visit. 

Again,  the  sales  manager  can  buy  lists  of  stockholders  of 
well-known  corporations,  the  presumption  being  that  a  stock- 
holder is  a  possible  investor.  There  are  men  who  travel  about 
gathering  stockholders'  lists.  A  man  by  having  one  share  of 
a  corporation  transferred  to  his  name  may  gain  access  to  the 
list  of  stockholders  of  practically  every  corporation.  These 
names  are  tabulated  and  sold  to  bankers,  usually  at  a  charge  of 
$1  per  hundred.  The  lists  are  chiefly  used  for  circularizing 
a  special  security,  particularly  a  preferred  stock.  They  indicate 
persons  who  have  in  the  past  purchased  securities  resembling 
those  about  to  be  offered,  and  the  presumption  naturally  exists 
that  such  people  may  be  induced  to  purchase  similar  securities 
of  another  similar  enterprise.  Again,  too,  the  settlement  of 
estates,  bequests,  and  sales  of  property  are  watched  with  the 
purpose  of  guiding  the  reinvestment  of  such  funds. 

Meetings  for  Salesmen. — As  stated  earlier,  all  investment 
dealers,  whether  the  large  bond  house  or  the  local  dealer,  rely 
primarily  on  personal  solicitation  to  sell  both  bonds  and  stocks. 
To  supply  the  salesmen  with  the  proper  information,  meetings 
are  held  at  regular  intervals  at  which  a  member  of  the  buying 
department  or  the  sales  manager,  or  in  the  case  of  the  small 
local  dealer,  the  proprietor  himself,  explains  in  great  detail 
the  new  issue  of  bonds  or  stocks  that  the  salesmen  will  be  asked 
to  work  upon.    In  this  talk  the  "selling  points"  of  the  issue  will 


VII  ]  NEW  COMPANIES  IN  ESTABLISHED  FIELDS  73 

be  brought  into  bold  relief.  If  it  is  a  public  utility  issue  the 
salesmen  will  be  told  all  about  the  locality,  its  geography,  in- 
dustries, and  potential  economic  possibilities.  In  the  case  of 
large  new  issues  with  which  the  organization  proposes  to 
become  permanently  identified  the  entire  selling  force  may  be 
taken  over  to  inspect  the  property.  In  addition  to  all  the  sell- 
ing points,  a  good  sales  manager  will  probably  take  up  in  detail 
all  the  possible  objections  and  reasons  for  declining  to  buy  with 
which  the  salesmen  will  be  confronted.  Most  of  all,  the  sales 
manager  will  seek  to  instil  in  the  men  a  real  enthusiasm  for 
the  issue.  If  he  understands  his  work  he  will  succeed  in 
making  each  man  feel  that  the  issue  is  a  remarkable  investment 
opportunity,  one  which  it  is  a  real  privilege  to  participate  in. 
If  the  manager  succeeds  in  creating  this  enthusiasm  the  issue 
will  be  sold;  otherwise  it  will  not.  No  amount  of  statistical 
information  will  serve  as  a  substitute  for  enthusiasm. 

Bond  Circulars. — As  a  help  for  the  salesmen  and  as  a 
written  memorandum,  the  bond  house  will  supply  its  men  with 
the  bond  circular.  This  is  the  only  advertising  matter  used. 
And  so  hidebound  and  sensitive  is  investment  opinion  that  the 
bond  circular  must  conform  exactly  to  established  practice  or 
else  it  prejudices  the  possible  investor  against  the  issue.  Its 
tone  must  be  direct,  formal,  critical,  and  it  must  be  absolutely 
devoid  of  demonstratives  and  superlatives.  As  a  general  rule 
the  higher  the  investment  grade  of  the  issue  the  more  colorless 
and  unenthusiastic  will  the  circular  appear.  The  bond  circular 
should  merely  state  facts;  adjectives,  enthusiasm,  and  "punch" 
are  to  be  supplied  by  the  bond  salesman  himself.  In  form 
the  typical  bond  or  high-grade  investment  preferred  stock 
circular  consists  of  a  four-page  leaflet,  printed  on  a  good 
quality  of  laid  paper.  The  first  page  consists  of  a  brief  sum- 
mary of  the  issue,  with  the  investment  dealer's  name  at  the 
bottom.     The  second,  third,  and,  if  need  be,  the  fourth  pages 


74  CORPORATION  FINANCE  [VI! 

of  the  circular  are  occupied  with  the  "President's  letter."  This 
is  a  comprehensive  account  of  the  securities  offered,  the  nature 
of  the  enterprise  itself,  its  capitalization,  and  earnings.  These 
letters  are  seldom  if  ever  written  by  the  president  of  the  com- 
pany; he  merely  signs  them  in  his  official  capacity.  The  true 
author  is  some  member  of  the  bond  house  whose  especial  busi- 
ness it  is  to  prepare  them  as  a  part  of  the  general  machinery 
of  selling. 

The  Real  Function  of  Investment  Bankers. — Reference  has 
been  made  already  to  the  care  exercised  by  the  reputable  in- 
vestment house  in  the  purchase  of  securities.  This  is  of  great 
service  to  the  investor  and  the  community.  The  investment 
banking  house  of  good  standing  ranges  itself  always  on  the 
side  of  established  business  enterprise,  tried  business  judgment, 
and  the  conservative  and  responsible  management  of  property. 
Its  advice  concerning  the  purchase  of  securities  is,  unfortu- 
nately, invariably  biased  by  the  goods  on  its  own  shelves,  and 
too  frequently  by  the  length  of  the  profit,  because  such  bank- 
ing houses  are  still  primarily  merchants  of  securities  rather  than 
counselors.  Yet  the  counsel  of  a  high-grade,  long-established 
bond  house  is  almost  invariably  sounder  than  the  untutored 
and  casual  judgment  of  the  customer  himself  or  the  haphazard 
opinions  he  may  glean  from  his  friends  and  acquaintances. 
The  bond  house  has  its  reputation  at  stake,  and  it  knows  that 
an  untarnished  reputation  is  the  most  valuable  asset  it  may 
acquire.  An  unrefiective  or  a  selfishly  narrow  opinion  on  any 
security  will  remain  lasting  evidence  of  either  faulty  judgment 
or  downright  misrepresentation. 

The  fairness  of  attitude  toward  competitors  shown  by  the 
high-grade  investment  houses  is  not  attained  in  any  other  busi- 
ness. An  employee  of  a  reputable  organization  will  not  "knock" 
the  securities  offered  by  other  houses,  much  less  misrepresent 
them,  provided  they  are  inherently  good.    Like  all  salesmen  he 


VII  ]  NEW  COMPANIES  IN  ESTABLISHED  FIELDS  75 

may  declare  that  his  own  wares  are  the  best,  but  such  pride  will 
not  be  carried  to  the  degree  of  disparaging  his  competitor's 
goods  unless  they  are  undisputably  bad,  and  in  such  cases  he 
will  be  content  to  point  out  their  weaknesses  in  general  terms. 


I 


CHAPTER  VIII 

RAILROADS  AND  CONSTRUCTION  COMPANIES 

Simplicity  of  the  Financial  Plan The  financial  plan  of  a 

new  railroad  is  in  certain  respects  a  simpler  and  in  certain 
respects  a  more  complex  problem  than  that  of  either  a  manu- 
facturing or  a  local  utility  company.  It  is  simpler  because 
there  are  ordinarily  fewer  kinds  of  securities  and  less  intricate 
conditions  of  issue.  It  is  more  complex  because  the  actual 
construction  is  usually  undertaken  by  an  intermediate  finance 
company,  the  fortunes  of  which  largely  mould  the  financial 
plan  of  the  railroad. 

The  amount  of  new  railroad  construction  since  1912  has 
been  very  small,  indeed,  and  by  far  the  largest  part  of  this 
has  been  the  building  of  small  subsidiary  ofifsprings  of  the 
larger  systems.  In  fact,  it  may  be  said  new  independent  rail- 
road construction  has  been  a  negligible  element  of  our  indus- 
trial life  since  the  panic  of  1907.  In  strictness,  of  course,  a 
discussion  of  the  promotion  and  the  financial  plan  of  a  new 
railroad  excludes  these  branch  and  connecting-line  roads  built 
by  the  larger  systems.  Yet  these  usually  came  into  existence 
as  separate  corporations,  although  their  parentage  is 
thoroughly  recognized,  and  the  steps  of  such  promotions  are 
often  strikingly  like  those  of  the  smaller  independent  systems. 

Private  and  Public  Aid  Extended  to  Original  Railroads. — 

Originally  the  new  railroad  was  a  civic  improvement.  The 
Baltimore  and  Ohio  Railroad  was  built  in  order  to  give  Balti- 
more access  to  the  region  beyond  the  Alleghany,  the  original 
New  York  and  Erie  in  order  to  give  the  lower  tier  of  New 
York  counties  access  to  a  market.     When  capital  was  being 

76 


VIII  ]        RAILROADS  AND  CONSTRUCTION  COMPANIES  77 

gathered  for  the  Western  Railroad  of  Massachusetts,  clergy- 
men preached  about  the  economic,  social,  and — by  implication 
— the  moral  value  of  the  enterprise.  Often,  in  order  to  stimu- 
late subscriptions,  great  mass  meetings  were  held  along  the 
line  of  the  proposed  road  and  local  newspapers  lent  their 
editorial  and  news  pages  to  the  prospective  enterprise.  Often 
there  was  a  house-to-house  canvass  for  subscriptions,  similar  to 
those  in  behalf  of  the  Liberty  Loans  of  the  Great  War;  large 
areas  of  Philadelphia  inhabited  by  people  of  moderate  means 
were  canvassed  in  behalf  of  the  building  of  one  of  the  early 
sections  of  the  Pennsylvania  Railroad. 

In  addition  to  the  private  aid  extended  to  the  new  railroad 
enterprise,  towns,  counties,  states,  and  the  national  govern- 
ment granted  them  lands,  money,  and  credit.  In  New  England 
the  towns  would  issue  their  bonds  and  then  with  the  proceeds 
buy  the  bonds  of  the  railroad  enterprise.  In  sections  of  the 
Middle  West  and  South  the  states  or  territories  would  com- 
monly grant  land,  and  in  the  Far  West  land  grants  were  made 
by  Congress.  Many,  perhaps  most,  of  the  new  enterprises 
could  not  be  made  to  pay  immediately,  owing  to  the  unde- 
veloped sections  of  the  country  and  the  large  expenses  of 
operation.  Consequently  most  of  them  failed.  In  the  case  of 
the  New  England  enterprises  the  towns  were  forced  to  shoulder 
a  new  burden  of  debt,  and  elsewhere  the  bondholders  lost 
practically  their  entire  investment.  Yet  in  spite  of  the  indi- 
vidual losses,  the  waste  of  public  lands,  and  the  misuse  of 
public  credit,  it  is  doubtful  if  the  railroads  could  have  been 
built  so  quickly  or  extended  so  rapidly  in  any  other  way. 
New  lands  were  opened  up  long  before  conservative  judgment 
would  have  prompted,  and  once  opened  up  became  a  national 
asset  of  great  value.  The  hectic  finance  of  early  railroad- 
building  was  the  price — on  the  whole  a  very  cheap  price — 
which  the  country  paid  for  the  marvelous  industrial  expansion 
which  followed  the  extension  of  cheap  transportation. 


78  CORPORATION  FINANCE  [VIII 

Many  of  the  methods  pursued  in  these  early  promotions 
are  still  followed,  without  the  use  and  abuse  of  public  credit 
and  without  the  glamour  of  public  acclaim.  The  promoter 
is  usually  now  a  civil  engineer  who  has  had  some  practical 
experience  in  railroad  construction.  Quite  frequently  he  is  a 
native  or  resident  of  the  locality  in  which  he  proposes  to  build 
his  new  road.  At  all  events  he  makes  himself  popular  with  the 
influential  men  along  the  proposed  route.  He  secures  traffic 
agreements  with  the  connecting  lines  and  makes  the  necessary 
connections  with  bankers.  Subsequently  he  superintends  con- 
struction, and  after  the  completion  of  the  road  he  may  con- 
tinue to  operate  it. 

The  Construction  Company. — The  outstanding  feature  of 
railroad  promotion  is  the  construction  company.  This  element 
may  be,  and  often  is,  present  in  the  promotion  plans  of  other 
enterprises  which  involve  large  building  operations,  but  it  is 
an  almost  universal  adjunct  of  a  railroad  promotion.  Many 
forms  of  construction  companies  have  existed  in  the  past. 
The  two  which  have  become  classic  in  the  literature  of  railroad 
promotions  are  the  Credit  Mobilier,  the  construction  company 
for  the  original  Union  Pacific,  and  C.  Crocker  and  Company, 
the  construction  company  for  the  original  Central  Pacific.  The 
construction  of  the  Central  Pacific  Railroad  (the  role  in  it 
played  by  C.  Crocker  and  Company  and  the  four  evil  geniuses 
of  the  undertaking,  Collis  P.  Huntington,  Leland  Stanford, 
Charles  Crocker,  and  Mark  Hopkins)  is  a  story  of  mis- 
representation, deceit,  and  wanton  betrayal  of  trust,  far  more 
than  is  the  history  of  the  building  of  the  Union  Pacific. 

Procedure  in  Small  Railroad  Promotion. — The  typical 
procedure  in  the  promotion  of  a  small  railroad  follows  certain 
established  lines.  Several  of  the  leading  stockholders  form  a 
corporation  to  the  share  capital  of  which  they  subscribe  in 


VIII  ]        RAILROADS  AND  CONSTRUCTION  COMPANIES  79 

cash.  This  independent  corporation  is  now  given  some 
fictitious  name,  say,  the  Alleghany  Construction  Company. 
The  railroad  corporation,  having  acquired  its  charter  and 
certificate  of  incorporation  but  owning  as  yet  no  property,  then 
enters  into  a  contract  with  the  construction  company  covering 
the  actual  building  of  the  road.  Sometimes  the  title  to  the 
right  of  way  is  acquired  directly  by  the  railroad,  but  more  often 
by  the  construction  company.  The  contract  between  the  two 
provides  that  for  every  section  of  i,  lo,  or  lOO  miles  of  com- 
pleted road  turned  over  by  the  construction  company  to  the 
railroad,  the  latter  will  surrender  to  the  construction  company 
a  certain  number  of  bonds  and  stocks  of  the  railroad.  The 
first  section  of  the  road  is  built  by  the  money  subscribed  by 
the  stockholders  of  the  construction  company.  The  con- 
struction company  meets  the  cost  of  the  second  section  from 
the  proceeds  of  the  sale  to  the  public  of  the  bonds  and  a  part 
at  least  of  the  stock  received  by  the  construction  company 
from  the  railroad.  For  this  second  section,  completed,  the 
construction  company  receives  another  block  of  securities, 
which  are  sold  to  meet  the  cost  of  the  following  sec- 
tion. The  process  is  continued  until  the  last  section  is 
completed. 

As  a  result  of  this  procedure,  the  construction  company 
ends  by  owning  the  margin  or  remainder  of  the  securities  of  the 
road  not  actually  sold  to  secure  the  money  for  the  labor  and 
materials  needed  in  construction.  Provided  these  remaining 
securities — as  is  presumed,  although  not  always  true — tare 
worth  more  than  the  stock  capital  originally  subscribed  by  the 
stockholders  of  the  construction  company,  the  latter  will  have 
realized  a  profit.  These  securities  remaining  in  its  hands  may 
be  divided  among  the  shareholders  of  the  construction  com- 
pany, or  sold  for  cash  and  the  proceeds  divided. 

In  rare  instances  the  construction  company  is  kept  alive  as 
an  investment  company.     The  Aroostook  Construction  Com- 


80  CORPORATION  FINANCE  [  VIIl 

pany  was  incorporated  February  28,  1891,  for  the  purpose  of 
building  the  Bangor  and  Aroostook  Railroad.  The  construc- 
tion company  had  left  in  its  treasury,  after  completing  the 
railroad,  practically  all  the  railroad's  stock.  Instead  of  divid- 
ing or  selling  this  stock  the  construction  company  has  been 
continued  as  a  kind  of  investment  and  controlling  company  for 
the  railroad.  As  things  now  stand  the  construction  company, 
with  a  capital  stock  of  $500,000,  owns  virtually  all  of  the 
railroad's  $3,800,000  of  common  stock,  which  controls  the 
railroad,  representing  an  investment  of  approximately  $30,- 
000,000. 

Sale  of  Securities. — In  the  early  period  of  railroad-building 
the  members  of  the  construction  company,  individually  or  in  the 
name  of  the  railroad,  sought  to  sell  the  securities  to  the  public. 
This  was  entirely  satisfactory  so  long  as  the  public  continued 
to  buy  the  bonds  of  the  unfinished  road ;  but  when  the  con- 
struction company  failed  to  effect  a  steady  outlet  of  the  securi- 
ties and  it  became  choked  with  undigested  obligations  of  the 
railroad  it  was  short  of  money  to  pay  for  materials  and  labor. 
Work  ceased  and  the  whole  enterprise  came  to  a  deadlock. 
Sometimes  a  new  construction  company  was  formed  to  assume 
the  obligations  and  assets  of  the  old,  but  more  often  the  rail- 
road and  the  construction  company  failed  together.  Several 
successive  construction  companies  for  instance  were  used  in 
building  the  Pacific  railroads. 

Of  late  years  the  construction  company  has  assured  itself 
of  an  outlet  for  its  securities,  as  one  of  the  necessary  pre- 
requisites of  starting  the  whole  enterprise,  by  contracting  with 
bankers  for  their  sale  to  the  public.  The  bankers,  in  con- 
sideration of  liberal  commissions  and  stock  bonuses,  agree  to 
buy  the  bonds  of  the  construction  company  for  cash  as  rapidly 
as  they  are  received  from  the  railroad.  Granting  the  integrity 
and  selling  power  of  the  bankers  the  construction  company 


VIII]       RAILROADS  AND  CONSTRUCTION  COMPANIES  8l 

becomes  assured  of  sufficient  money  to  carry  out  its  building 
contracts  with  the  railroad. 

Sources  of  Profit. — Three  sources  of  profit  fatten  the 
treasury  of  the  construction  company — profit  on  land  pur- 
chased on  account  of  the  road,  profit  on  labor  and  materials 
furnished  for  construction  purposes,  and  profit  from  the  direct 
sale  of  the  railroad  securities.  Aside  from  the  ability  of  the 
construction  company  to  market  the  railroad  bonds,  a  matter 
which  is  paramount  to  the  success  of  the  whole  enterprise,  the 
success  to  the  construction  company  turns  upon  the  character 
of  the  building  contract  upon  which  the  relations  of  the  two 
corporations  are  based.  As  the  few  stockholders  of  the  con- 
struction company  are  the  influential  stockholders  of  the  rail- 
road company,  this  contract  is  usually  conspicuously  favorable 
to  the  former  corporation — so  favorable  indeed  is  it  sometimes 
that  the  few  within  the  inner  ring  reap  an  inordinate  sur- 
reptitious profit.  In  consequence  the  new  road  emerges  with 
a  large  volume  of  stock  and  bonds,  which  stifle  it  almost  before 
it  is  born.  In  a  few  notorious  instances,  like  C.  Crocker  and 
Company  in  connection  with  the  building  of  the  Central 
Pacific,  the  individual  members  of  the  construction  company 
reap  exorbitant  secret  profits  by  personally  selling  their  com- 
pany supplies  and  construction  material  at  prices  above  the 
market.  In  that  instance,  to  give  a  semblance  of  legal  im- 
munity, C.  Crocker  resigned  from  the  directorate  of  the  rail- 
road in  order  to  devote  himself  to  the  construction  contracts, 
and  his  brother  took  his  place  on  the  railroad's  board. 

The  Building  of  the  Hampden  Railroad. — One  of  the  most 
notorious  of  construction  company  exploitations  was  that  of 
the  building  of  the  Hampden  Railroad.  The  outstanding  facts 
seem  to  be  as  follows  :  In  1 910,  Charles  Mellen,  then  president 
of  the  Boston  and  Maine  Railroad,  ihe  latter  having  passed 


82  CORPORATION  FINANCE  [  VIII 

under  the  control  of  the  New  York,  New  Haven  and  Hartford 
Railroad,  conceived  the  idea  of  connecting  the  Massachusetts 
Central,  a  poor  single-track  subsidiary  of  the  Boston  and 
Maine,  with  the  New  York,  New  Haven  and  Hartford  at 
Springfield.  This  link  would  represent  about  15  miles  of 
line.  It  would  enable  the  New  Haven  and  the  Boston  and 
Maine  roads  to  run  trains  from  New  York  to  northern  New 
England  points  over  their  own  tracks.  Mellen  gave  one  Gil- 
lett,  then  head  of  the  Woronoco  Construction  Company,  to 
understand  that  the  Boston  and  Maine  would  lease  the 
Hampden  Railroad  when  built,  and  assume  its  bonds  and 
stocks.  This  understanding  was  ratified  by  both  the  directors 
and  the  stockholders  of  the  Boston  and  Maine. 

Gillett  and  his  business  associates  then  formed  the 
Hampden  Railroad  Company,  of  which  Gillett  was  president. 
Gillett  next  formed  the  Hampden  Investment  Company,  with 
himself  as  president,  to  take  over  the  securities  of  the  railroad 
as  rapidly  as  issued  and  to  supply,  through  loans  on  these 
securities,  the  necessary  construction  money.  The  contract 
which  Gillett,  as  personifying  the  Hampden  Railroad  Company, 
made  with  himself,  as  personifying  the  Woronoco  Construc- 
tion Company,  involved  the  building  of  the  road  at  definite 
unit  costs,  and  cost  plus  10  per  cent.  The  road  was  built  with 
such  heedless  extravagance,  considering  its  situation,  as  to 
suggest  that  the  contractor  labored  arduously  to  increase  the 
cost,  both  by  extravagant  expenditures  and  by  excessive  and 
surreptitious  profits.  Most  of  the  work  of  excavation,  for 
example,  was  sublet  to  other  contractors.  On  the  excavation 
covered  by  these  subcontractors  the  Hampden  Railroad  Com- 
pany paid  the  Woronoco  Construction  Company  $2,686,093, 
whereas  the  Woronoco  Construction  Company  paid  the  sub- 
contractors $1,595,270.  The  apparent  profit  to  Gillett's  con- 
tracting company  was,  therefore,  $1,090,824,  or  upwards  of 
40  per  cent  of  what  was  paid  the  subcontractors.     Gillett's 


VIII  ]        RAILROADS  AND  CONSTRUCTION  COMPANIES  83 

report  to  the  Massachusetts  Commission  showed  a  cost  of 
$4,396,000,  or  $300,000  a  mile!  At  that  time,  in  its  nearly 
finished  state,  the  road  was  only  14.8  miles  in  length  and 
reached  no  important  terminals.  It  had  only  four  insignificant 
way  stations.  The  Interstate  Commerce  Commission  report 
states,  "The  Hampden  Railroad  runs  through  a  stretch  of 
country  which  presents  no  unusual  difficulties  in  the  construc- 
tion of  a  railroad.  It  was  admitted  that  by  using  a  different 
location,  by  making  the  road  somewhat  longer  with  somewhat 
less  favorable  grades,  it  could  probably  have  been  built  for 
from  $35,000  to  $40,000  per  mile."  A  profit,  however,  was  not 
realized  by  anyone  because  the  Massachusetts  Public  Service 
Commission  would  not  allow  these  inordinate  expenditures  to 
be  capitalized,  and  the  burden  shifted  to  the  shoulders  of  the 
Boston  and  Maine.  And  when  ultimately  the  Boston  and 
Maine  passed  into  the  hands  of  receivers,  the  Hampden  Rail- 
road, the  Hampden  Investment  Company,  and  the  holders  of 
the  latter's  notes  were  left  without  a  foster  parent  to  assume 
the  burden. 

Legitimate   Functions   of   the   Construction   Company. — 

Fraught  though  it  is  with  real  and  apparent  fraud, 
the  construction  company  serves  several  useful  purposes  in 
railroad  promotion.  Ordinarily  the  new  railroad  would  find 
it  very  expensive  to  secure  its  right  of  way  if  it  attempted  to  do 
so  openly.  If  the  land  to  be  used  by  the  new  road  is  quietly 
bought  in  by  the  construction  company,  with  very  little  stir, 
a  lower  price  is  invariably  paid  and  no  antagonisms  are  en- 
gendered. Again,  the  use  of  the  construction  company  permits 
the  railroad  to  issue  "full-paid  and  non-assessable"  stock,  since 
there  is  no  issue  of  stock  for  specific  property  that  can  be  inde- 
pendently valued.  The  road  merely  surrenders  a  certain 
amount  of  securities  for  a  certain  quantity  of  finished  road, 
and  no  one  can  say  that  it  has  not  received  full  value.    Again, 


84  CORPORATION  FINANCE  [  VIII 

too,  the  road  knows,  or  should  know,  the  exact  cost  of  the  road 
in  terms  of  the  only  thing  the  railroad  can  give — its  own 
securities.  So  that  in  spite  of  the  ill  repute  into  which  the 
construction  company  has  fallen,  its  use  is  still  retained  in 
promotions.  One  may  sincerely  believe,  however,  that  the  old 
profiteering  by  insiders  very  rarely  occurs  now. 

Predominance  of  Bond  Issued. — With  the  exception  of  the 
role  of  the  construction  company,  the  financial  side  of  railroad 
promotion  is  relatively  simple.  After  the  promoter  has  se- 
cured the  right  of  way  he  arranges  with  bankers  to  secure  the 
necessary  money.  As  the  promoter  is  ordinarily  a  railroad 
engineer,  the  usual  practice  is  to  leave  to  him  the  management 
of  the  construction  company,  the  purchase  of  material,  the 
hire  of  labor,  and  the  arrangement  of  traffic  agreements  with 
other  lines.  The  bankers  confine  their  attention  to  the  actual 
financial  plan  and  the  more  difficult  task  of  the  sale  of 
securities. 

Ordinarily  only  first  mortgage  bonds  and  common  stock 
are  issued,  the  former  representing  the  actual  cost  of  the  road 
and  the  latter  the  prospective  profits  of  promotion.  This  is 
possible  because  the  class  of  what  one  might  call  "speculative 
investors,"  to  whom  bankers  would  probably  sell  the  securities 
of  an  embryo  railroad,  would  not  buy  preferred  stocks,  but 
would  insist  on  just  the  things  bonds  and  common  stock  can 
give — apparent  security  and  an  interest  in  the  prospective 
profits.  There  are  no  earnings  to  show,  and  if  prospective 
earning  figures  are  vouchsafed  they  can  be  made  liberal ;  conse- 
quently if  a  large  number  of  bonds  are  issued  in  the  beginning 
it  does  not  create  a  prejudice  against  the  enterprise.  Investors 
have  become  accustomed  to  large  bonded  debts  for  railroads 
and  are  not  frightened  by  them.  Consequently  the  bankers  can 
formulate  a  financial  plan  in  which  the  par  value  of  the  bonds 
may  equal  or  even  somewhat  exceed  the  actual  cash  expendi- 


VIII  ]       RAILROADS  AND  CONSTRUCTION  COMPANIES  85 

tures.  Even  then,  as  much,  if  not  all,  of  the  land  on  which  the 
road  is  built  may  be  a  free  gift,  it  is  quite  within  the  truth  to  say 
that  the  actual  property  of  the  new  road  exceeds  the  par  of  its 
bonds. 

Common  stock  is  issued  at  the  time  of  promotion  in  very 
liberal  amounts.  It  is  the  lubricant  which  makes  the  wheels  of 
promotion  turn  easily  and  smoothly;  it  costs  the  road  nothing. 
With  the  road  unbuilt,  the  value  of  the  common  stock  is  very 
little  and  that  little  is  prospective  earning  capacity,  to  be  made 
actual  only  through  the  concerted  endeavor  of  the  very  men  to 
whom  it  goes  as  compensation  for  promotion  services.  In  this 
way  the  amount  of  the  interest-bearing  securities  and  the 
charges  upon  them  may  be  reduced  to  a  minimum.  Were  it 
possible  to  sell  preferred  stock  alone,  or  even  preferred  stock 
with  a  liberal  bonus  of  common  stock,  as  is  done  in  the  case  of 
industrials,  small  railroads  could  be  promoted  without  the 
initial  burden  of  a  heavy  bond  issue.  Unfortunately,  however, 
the  buyers  of  railroad  securities  demand  mortgage  bonds  for 
their  money  and  the  pattern  of  the  financial  plan  must  be  cut 
accordingly;  and  to  this  policy  of  issuing  a  predominance  of 
bonds  over  stocks,  able  authorities  attribute  the  general  un- 
soundness of  railroad  finance  in  the  years  just  before  the 
Great  War. 

Description  of  an  Actual  Promotion. — The  case  of  an  actual 
promotion  of  a  small  road  may  be  used  to  illustrate  the  pro- 
cedure outlined  above.  In  the  account  some  of  the  details  con- 
cerning underwriting  syndicates  are  omitted  as  well  as  certain 
unessential  matters  which  needlessly  complicate  the  description 
for  the  purpose  of  illustration.  A  small  road  of  60  miles  was 
projected  through  a  new  country.  The  promoter  was  a  civil 
engineer  who  had  previously  had  charge  of  construction  for  a 
large  trunk  line  extending  through  the  section.  He  was 
thoroughly  familiar  with  the  railroads  in  the  region  as  well  as 


86  CORPORATION  FINANCE  [VIII 

with  the  general  economic  conditions.  Through  persuasion, 
helped  by  a  pleasing  personality,  he  secured  the  gift  of  the 
entire  right  of  way  and  the  terminal  sites  in  three  of  the  five 
towns  through  which  the  road  was  to  pass.  The  promoter  and 
two  banking  houses  next  formed  a  construction  company, 
which  assumed  the  title  to  the  real  estate  to  be  used  by  the  new 
railroad.  The  railroad  company  was  then  incorporated,  after 
the  ne-:essary  legislative  sanction  had  been  obtained.  The  com- 
pleted road  cost,  for  the  labor  of  grading,  for  third  quality 
ties,  for  6o-pound  relay  rails,  the  necessary  sidings  and  yards, 
and  for  the  erection  of  five  small  stations  and  one  terminal, 
approximately  $850,000  in  actual  money.  The  promoter  and 
the  bankers,  as  directors  of  the  railroad,  contracted  with  them- 
selves as  the  executive  committee  of  the  construction  company 
to  deliver  over  to  the  construction  company  $160,000  in  first 
mortgage  6  per  cent  bonds  and  $180,000  in  common  stock  in 
return  for  each  section  of  10  miles  of  completed  road.  At  the 
same  time  the  bankers  contracted  with  themselves  as  the  execu- 
tive committee  of  the  construction  company  to  buy  the  bonds  of 
the  company  at  90  per  cent,  provided  they  were  allowed  in  addi- 
tion $120,000  in  stock  for  each  lo-mile  section.  The  prospec- 
tive profit  to  the  construction  company  was  therefore  $60,000 
par  value  of  stock  for  each  section,  since  the  actual  money 
received  from  the  bankers  was  entirely  absorbed  by  the  direct 
outlay  for  construction.  The  first  lO-mile  section  was  com- 
pleted with  money  subscribed  by  the  construction  company's 
stockholders — the  promoter  and  bankers.  Thereafter  each 
section  was  built  from  the  proceeds  of  the  sale  to  the  bankers 
of  the  bonds  received  for  completing  the  previous  section.  At 
the  same  time  the  promoter  arranged  with  the  manufacturers 
of  equipment  to  buy  two  small  "rebuilt"  locomotives  for 
$25,000  and  to  pay  for  them  by  the  delivery  of  $27,500  par 
value  of  the  first  mortgage  bonds  of  the  railroad.  He  also 
purchased  two  second-hand  passenger  coaches  and  a  combina- 


Vlir         RAILROADS  AND  CONSTRUCTION  COMPANIES  87 

tion  passenger  and  baggage  car  for  $6,000  in  first  mortgage 
bonds.  The  freight  cars  of  other  Hnes  were  hired  to  save  the 
cost  of  freight  equipment.  Summarizing  the  financial  plan 
employed  in  this  instance,  there  would  be  outstanding  at  the 
completion  of  the  road : 


First   Mortgage   6%    Bonds 

Issued  for  the  following  purposes  : 
Roadbed   (Construction  Company) 

Locomotives    

Coaches    

Authorized 
$3,000,000 

2,000,000 

Issued 

$960,000 

25,000 

6,000 

Stock 

Issued  to : 

Construction     Company 

Promoter   in    return    for   services, 
including  securing  of  land 

$1,080,000 
500,000 

$  991,000 


$1,580,000 


The  vital  point  of  the  financial  plan  of  any  promotion  of 
this  kind,  the  relative  amount  of  fixed  charges  the  business  can 
carry  wisely,  was  not  considered,  because  the  promoter  had 
assured  himself  of  enough  traffic  to  pay  at  least  6  per  cent  on 
the  cost  of  construction  and  had  no  need  to  plan  further. 

The  device  of  paying  for  equipment  in  bonds  is  very  com- 
mon. In  the  case  of  a  large  order  the  equipment  companies  re- 
quire that  an  equipment  trust  be  created.  In  cases  of  smaller 
sales  at  least  one  among  the  many  competing  equipment  manu- 
facturers will  accept  bonds  in  payment  for  equipment,  provided, 
of  course,  there  is  reasonable  chance  of  selling  them.  The  pro- 
cedure resembles  that  of  New  England  manufacturers  of  textile 
machinery  in  accepting  stock  of  new  cotton  mills  as  payment 
for  mill  equipment. 

Promotion  of  a  New  Interurban  Electric  Railroad. — 
Closely  related  in  most  respects  to  the  procedure  m  the  promo- 
tion of  a  new  steam  railroad  is  that  of  a  new  interurban  electric 


88  CORPORATION  FINANCE  \  VIII 

railroad.  In  the  period  from  1897  to  1907  there  was  a  very 
extensive  development  of  interurban  properties  all  over  the 
eastern  and  central  states.  Enormous  amounts  of  money  were 
sunk  in  these  projects  on  the  expectation  that  they  would 
revolutionize  passenger  transportation.  Many  had  been  pro- 
moted by  men  who  wished  merely  to  sell  land  along  the  right 
of  way.  The  large  majority  of  these  roads  were  at  first  only 
partially  successful,  even  though  little  or  no  depreciation  was 
charged  against  earnings.  Subsequently  a  very  large  propor- 
tion actually  failed.  Those  which  were  able  to  keep  out  of  the 
hands  of  receivers  were  in  the  majority  of  cases  burdened  with 
only  a  low  bonded  debt.  But  a  very  few  have  proved  in  the 
long  run  to  be  financially  successful  or,  indeed,  sufficiently 
remunerative  to  have  justified  their  original  construction. 

Since  the  Great  War  the  conditions  of  the  interurban  have 
gone  from  bad  to  worse.  An  illustration  of  the  extreme  condi- 
tions is  the  Bay  State  Street  Railway.  This  covers  all  of  the 
eastern  part  of  Massachusetts  (with  the  exception  of  metro- 
politan Boston) — one  of  the  most  densely  populated  and  pros- 
perous sections  of  the  country.  Owing  to  increasing  costs  of 
operation,  steadily  depreciating  equipment,  competition  with 
automobiles,  and  a  multitude  of  lesser  causes,  the  road  ceased 
to  earn  enough  to  pay  its  interest  charges.  Fares  were  raised 
on  many  of  the  lines,  but  without  avail.  It  passed  into  the 
hands  of  a  receiver  in  December,  191 7. 

Neglect  of  Depreciation  Reserves. — The  pronounced  weak- 
ness of  the  financial  plans  of  nearly  all  electric  railways  is  the 
neglect  of  the  importance  of  depreciation.  A  road  over- 
burdened by  bonds  might  survive  for  the  first  half-dozen  years, 
or  even  first  ten  years,  because  new  equipment  and  a  new  road- 
bed could  be  used  for  a  few  years  without  expensive  replace- 
ments. But  sooner  or  later  large  renewals  become  absolutely 
necessary.      Without   a   depreciation    reserve    these    renewals 


VIII  ]       RAILROADS  AND  CONSTRUCTION  COMPANIES  89 

must  be  capitalized  and  the  money  to  pay  for  them  obtained  by 
the  sale  of  more  bonds.  This  course  brings  the  road  deeper 
and  deeper  into  the  quagmire  of  bonded  debt. 

Rigidity  of  Modern  Tests. — The  promoter  of  electric  rail- 
ways must  nowadays  subject  his  enterprise  to  more  rigid  tests 
than  the  enthusiasm  of  the  inhabitants  along  the  proposed  line. 
After  securing  his  necessary  franchises  he  must,  like  the  pro- 
moter of  any  other  railroad  or  public  utility,  be  able  above  all 
else  to  predict  the  demands  of  the  community  for  the  new  serv- 
ice, now  and  in  the  near  future.  With  the  help  of  an  engineer 
he  can  predict  costs  with  a  surprising  degree  of  accuracy;  but 
the  probable  traffic  and  the  probable  effect  of  the  opening  of 
new  transportation  upon  traffic  are  more  difficult.  In  the  actual 
procedure  the  promotion  of  the  interurban  electric  company 
and  the  steam  railway  differ  but  little.  Generally  speaking, 
the  attempt  has  been  made  to  use  a  smaller  proportion  of  bonds 
in  the  financial  plan  of  the  former.  Preferred  stocks  are  used 
in  a  larger  number  of  cases;  yet  such  statements  are  only 
indicative  of  general  tendencies.  The  bankers  expect  a  slightly 
lower  commission  for  the  sale  of  the  securities  of  new  steam 
railway  companies  than  for  those  of  other  public  service  cor- 
porations, perhaps  because  the  former  are  now  usually  pro- 
moted in  close  connection  with  some  already  established 
railroad. 


CHAPTER  IX 

THE  PROMOTION  OF  PUBLIC  UTILITIES 

Differentiation  Between  Railroads  and  Public  Utilities. — 

Though  in  the  eyes  of  the  law,  railroads  and  traction  com- 
panies are  public  service  corporations  as  much  as  water,  gas, 
and  electric  light  companies,  certain  special  conditions  make  it 
simpler  to  consider  the  latter  group  alone,  under  the  general 
name  of  "local  public  utilities"  or  just  "pubHc  utilities."  Chief 
of  these  special  conditions  is  the  relatively  small  amount  of  the 
labor  cost  in  their  Expense  account.  In  this  respect  railroad 
and  traction  companies  are  in  as  sharp  contrast  with  them  as  are 
manufacturing  concerns. 

The  Promoter  of  a  New  Public  Utility. — The  promoter  of 
a  new  local  public  utility  is  now  quite  often  not  a  man  engaged 
in  the  business  of  operating  utilities.  Generally  speaking,  he 
is  a  "leading  citizen"  of  some  community,  who  is  spurred  on 
by  a  desire  to  improve  the  standing  or  economic  resources  of 
his  home  region.  Sometimes  this  motive  is  purely  altruistic, 
desiring  to  bring  about  a  community  improvement  as  a  social 
service;  sometimes  this  leading  citizen,  who  assumes  the  role 
of  the  promoter,  is  prompted  by  a  desire  to  raise  land  values, 
to  stimulate  industries,  or  even  to  sell  the  enterprise  merchan- 
dise; sometimes  it  is  a  mixture  of  motives,  not  the  least  of 
which  is  that  of  seeing  himself  as  the  president  of  the  only 
utility  the  town  can  support. 

The  Prospectus  and  Franchises. — In  any  case,  unless  he 
has  funds  of  his  own  to  start  the  company,  his  first  effort  must 
be  to  prepare  a  report  or  general  prospectus  in  order  to  interest 

90 


IX 1  THE  PROMOTION  OF  PUBLIC  UTILITIES  91 

banking  houses  in  the  possibiHties  of  his  undertaking.  To  make 
such  a  report  satisfactorily  he  must  above  all  else  be  able  to 
predict  the  demands  of  the  community  for  the  new  service, 
now  and  in  the  near  future,  and  must  be  able  to  form  an 
accurate  idea  of  the  influence  of  the  new  enterprise  on  the 
immediate  development  of  the  territory  it  serves.  This  is  an 
important  point.  It  very  frequently  happens,  as  in  parts  of 
New  England,  that  the  demand  for  electric  power  already 
exists  and  can  be  definitely  measured,  but  that  this  already 
existent  demand  cannot  be  increased.  A  new  railroad  will  it- 
self create  most  of  its  traffic  by  supplying  the  means  of  trans- 
portation for  ore,  coal,  or  other  natural  products  without  which 
the  road  would  not  be  constructed.  But  a  new  utility  cannot 
create  customers,  although  its  presence  may  stimulate  new 
uses  for  the  services  it  offers. 

The  promoter  of  lighting  companies  must  secure  the  active 
co-operation  of  local  interests,  especially  of  the  prominent 
business  men  and  the  politicians  of  the  community  concerned. 
Ordinarily  the  towns  and  municipalities  are  willing  to  grant  a 
liberal  franchise  to  any  promoter  who  is  in  a  position  to  give 
improved  lighting  service  or  cheaper  power,  and  his  efforts  will 
be  directed  toward  obtaining  the  grants  without  burdensome 
restrictions  and  for  a  long  period  of  time.  This  part  of  the 
promoter's  work  is  of  great  importance,  as  the  public  authorities 
will  invariably  grant  more  to  the  prospective  railroad  or  public 
service  company  before  the  service  is  begun,  from  a  sense  of 
expediency,  than  they  will  ever  grant  afterwards  from  a  sense 
of  justice. 

Cost  of  Construction  and  Probable  Earnings. — As  soon  as 
the  promoter  has  settled  in  his  mind  the  scope  of  the  new 
lighting  or  power  company  and  has  secured  the  necessary  public 
sanction,  whether  certificate  of  exigency,  or  franchise,  the 
next  task  for  him  is  to  compute  the  cost  of  the  building  of 


92  CORPORATION  FINANCE  1 IX 

his  new  undertaking  and  the  probable  earnings.  The  former 
can  be  determined  with  a  remarkable  degree  of  accuracy  by 
means  of  definite  provisional  contracts  entered  into  with  con- 
struction companies,  steel  mills,  and  the  manufacturers  of 
equipment.  If  the  promoter  is  personally  familiar  with  the 
price  of  materials  and  construction  within  the  field  of  the  new 
enterprise,  he  will  be  able  to  estimate  for  himself  the  cost 
of  construction.  In  case  he  is  not  familiar  with  these  facts 
he  will  enlist  the  help  of  an  engineering  firm  of  acknowledged 
standing  whose  estimates  will  be  relied  upon  by  the  men 
from  whom  he  is  to  ask  capital.  And  with  these  estimates 
completed  his  own  special  work  will  be  finished.  The  pro- 
moter will  then  seek  to  obtain  the  co-operation  of  bankers, 
construction  companies,  finance  companies,  underwriting 
syndicates,  and  all  the  intricate  machinery  of  modern  finance. 
These  phases  of  the  promotion  will  be  discussed  in  subse- 
quent chapters. 

Underestimated  Costs. — It  is  much  easier  to  form  proper 
estimates  of  the  costs  of  construction  and  gross  earnings 
of  small  properties  than  large.  For  example,  in  the  case 
of  a  small  hydro-electric  power  plant  in  the  South,  the 
promoter-engineer  estimated  the  entire  cost  of  construction 
and  equipment  at  about  $1,200,000;  the  actual  cost  was  about 
$1,100,000.  Such  a  case  of  overestimation  of  costs  is  almost 
unique,  but  the  discrepancy  between  the  "estimates  of  compe- 
tent engineers"  and  the  actual  costs  is  apt  to  be  much  less, 
proportionately,  in  small  enterprises.  The  firm  of  engineers 
which  built  the  Mississippi  River  power  plant  underestimated 
the  cost  by  several  million  dollars.  Owing  to  the  variety  of 
possible  unforeseen  contingencies  the  actual  cost  of  hydro- 
electric plants  is  apt  to  vary  from  the  estimated  cost  by  a 
larger  figure  proportionately  than  is  the  case  with  railroads 
and  lighting  and  traction  companies. 


IX]  THE  PROMOTION  OF  PUBLIC  UTILITIES  93 

Tests  of  Earning  Capacity. — The  banker  will  put  his  own 
special  group  of  experts  to  work  to  check  the  report  and 
estimates  of  the  promoter.  He  or  his  representative  will 
visit  the  town  where  it  is  proposed  to  build  or  acquire  the 
new  utility,  in  order  that  he  may  judge  for  himself  certain 
things  about  it;  he  will  estimate  what  proportion  of  the 
population,  from  geographical  position  and  general  level  of 
income,  might  be  expected  to  be  customers  of  the  new 
company. 

1.  Population. — Population  is  always  "estimated"  by  the 
promoter  and  these  estimates  are  invariably  too  high.  Not 
only  are  the  census  figures  inflated  by  unwarranted  additions 
since  the  last  census  but  neighboring  localities  are  included, 
notwithstanding  the  fact  that  the  utility  would  not  by  any 
stretch  of  the  imagination  reach  out  to  them.  Then,  too, 
even  if  the  exact  census  figures  are  used  there  is  a  marked 
difference  between  mere  population  and  prospective-customer 
population.  Scattered  farmers  in  outlying  rural  districts  are 
of  no  consequence  to  a  gas  or  electric  company,  although 
they  are  to  the  street  railway.  A  man,  wife,  and  thirteen 
children  living  in  a  hovel  on  the  far  outskirts  of  a  southern 
city  do  not  contribute  to  the  population  for  the  purpose  of 
computing  electric  light  earnings — useful  though  they  may 
be  in  determining  the  Congressional  representation. 

2.  Wealth  and  Industrial  Activity — The  wealth  and  in- 
dustrial prosperity  of  the  general  region  to  be  served  is  a 
matter  which  the  banker  must  study  with  great  care.  Com- 
munities in  the  United  States  may  be  roughly  divided  into 
three  classes  according  to  their  stage  in  what  may  be  called 
the  "economic  cycle."  There  are  communities  which  bear 
all  the  signs  of  vigorous,  healthy,  growing  youth.  Industrial 
activity  is  at  high  pressure.    There  are  no  houses  to  be  hired, 


94  CORPORATION  FINANCE  [IX 

no  unemployment.  New  workers  are  arriving  on  every  traia 
Capital,  costly  to  obtain,  is  nevertheless  in  great  demand. 
The  deposits  in  the  local  banks  increase  with  amazing  rapidity, 
yet  these  deposits  all  find  profitable  employment  at  home. 
This  is  the  stage  of  commercial  youth.  Later  on,  perhaps 
in  another  generation  or  in  another  hundred  years,  the  eco- 
nomic life  of  the  community  seems  to  show  signs  of  abating. 
There  are  well-established  and  widely  known  industries 
which  have  been  in  existence  for  many  years.  But  there  are 
no  new  industries.  There  is  little  unemployment,  but  few 
people  are  moving  in.  The  banks  are  operated  by  old  men 
who  are  content  to  let  well  enough  alone.  Deposits  are  station- 
ary, and  a  considerable  proportion  of  the  loans  are  placed  by 
notebrokers  among  outside  borrowers.  There  is  little  build- 
ing, and  houses  are  relatively  easy  to  rent  or  buy.  This  is 
the  maturity  or  "middle-life"  stage.  Finally,  perhaps  after 
several  more  generations,  the  community  shows  unmistakable 
signs  of  economic  decay.  Factories  are  deserted.  The  enter- 
prising young  men  and  women  leave  the  town.  The  only  faces 
one  meets  in  the  streets  are  those  of  old  men  or  ambitionless 
and  degenerate  young  men.  The  banks  have  relatively  large  de- 
posits— represented  in  considerable  part  by  savings  accounts. 
Except  as  accommodations  to  the  local  merchants,  relatively 
few  loans  are  made  to  the  depositors.  The  main  street  even  on 
Saturday  afternoon  carries  a  sleepy  atmosphere — except  now 
and  then  a  murder  by  the  degenerate  scion  of  one  of  the  old 
families  or  a  scandal  in  the  home  of  the  middle-aged  deacon. 
This  is  the  "old-age"  stage.  Truly  communities  have  a  life  cycle 
to  the  economist,  just  as  much  as  mountains  and  plains  to  the 
physiographist. 

It  is  of  great — even  controlling — importance  for  the  banker 
to  appreciate  fully  the  point  in  this  economic  cycle  at  which 
the  community  where  he  proposes  to  build  or  acquire  the  utility 
stands.  It  is  of  far  greater  importance  than  the  engineer's  ap- 


IX]  THE  PROMOTION  OF  PUBLIC  UTILITIES  95 

praisal  of  the  present  value  of  the  equipment  based  on  a  count 
of  the  poles  and  transformers  or  a  measurement  of  the  miles  of 
main.  A  railroad,  for  illustration,  serves  many  communities, 
so  that  the  decay  of  one  may  be  fully  compensated  for  by 
the  industrial  advance  of  another,  just  as  the  stability  and 
regularity  of  a  railroad's  earnings  is  assured  only  by  a 
diversity  in  the  character  of  its  freight.  But  a  public  utility 
serves  only  a  single  community.  Capital  placed  there  by  the 
banker  must  remain;  and  its  fortunes  or  misfortunes  are  the 
fortunes  or  misfortunes  of  the  community.  There  can  be  no 
distribution  of  risk,  no  balance  of  the  progress  of  one  com- 
munity against  the  decay  of  another.  Reference  will  be  made 
to  this  paramount  fact  later  in  this  chapter  in  connection  with 
the  discussion  of  the  financial  plan  to  be  followed  in  promo- 
tion projects. 

3.  Moral  Temper  of  the  Community. — Perhaps  next  in 
importance,  after  noting  the  economic  status  of  the  com- 
munity, the  banker  will  try  to  obtain  some  idea  of  its  moral 
temper.  Many  lines  of  evidence  bear  on  this.  The  banker's 
representative  will  ascertain  the  relative  thrift  of  the  inhabit- 
ants by  gauging  the  subscriptions  to  Liberty  Loans  and  War 
Saving  Stamps  and  the  deposits  in  the  savings  banks.  For 
thrift  has  a  moral  as  well  as  economic  significance.  The 
banker's  representative  would  have  noted,  in  the  old  days, 
the  relative  number  of  liquor  saloons,  their  patronage  and  the 
amount  of  liquor  shipped  in — now  he  will  try  to  find  out  the 
amount  of  bootlegging.  The  larger  the  proportion  of  a  man's 
income  goes  for  liquor,  the  smaller  the  proportion  for  the  elec- 
tric light  bill  of  his  home.  The  representative  will  note  the 
proportion  of  house-building  that  is  being  done  by  owner-occu- 
pants, for  owner-occupants  of  houses  furnish  the  backbone  of 
a  more  stable  population — and  besides,  a  man  will  wire  his 
own  house  when  he  will  not  undergo  the  same  expense  for  a 


96  CORPORATION  FINANCE  [IX 

tenant.  He  will  note  also  the  credit  ratings  of  the  local  mer- 
chants and  the  appearance  of  their  stocks  of  goods;  the  char- 
acter of  the  schools  and  the  proportion  of  taxes  devoted  to 
education;  the  contributions  of  the  locality  to  churches  and 
charities ;  the  general  appearance  and  the  moral  conditions  of 
the  "slums";  the  presence  of  graft  and  corruption  in  public 
life  and  the  statistics  of  crime  and  vice — these  and  many  other 
factors  will  supply  evidence  in  determining  the  prosaic  ques- 
tion :  Will  an  electric  light  company  pay  ? 

4.  Previous  Earnings. — There  are  now,  however,  far 
fewer  promotions  of  utility  projects  which  are  of  entirely 
new  construction  than  promotions  representing  the  remodel- 
ing, reorganization,  or  combination  and  extension  of  previously 
existing  small  utilities.  In  these  instances  the  outside  banker 
employs  all  the  tests  and  checks  outlined  above,  and  has  in 
addition  a  very  reliable  test  in  the  actual  earnings  in  previous 
years  of  the  utility  or  utilities  which  he  proposes  to  reorganize. 
When  a  small  electric,  gas,  or  water  plant  is  built  by  local 
men  the  promoters  are  actuated  partly  by  hope  of  profit 
and  partly  by  civic  pride,  but  they  seldom  have  the  requisite 
technical  skill  at  their  command  and  practically  never  under- 
stand the  intricacy  of  modern  public  service  problems.  Their 
enterprise  prospers  by  reason  of  the  mere  growth  of  the 
community,  but  their  management  is  inefficient  and  backward 
and  they  have  no  capital  for  extensions  and  improvements. 
The  same  conditions  may  prevail  in  the  adjoining  cities  and 
towns.  Then  an  electrical,  gas,  or  hydraulic  engineer  with 
banking  connections,  or  a  banker  with  an  engineer  as  an  asso- 
ciate, may  buy  the  local  enterprise  and  those  of  the  adjoining 
communities  with  the  purpose  of  reconstructing  them,  and  for 
this  purpose  form  a  new  corporation  to  assume  the  ownership 
of  the  franchise  and  the  physical  property  of  the  old  operating 
companies.     The  necessary  capital  for  the  extension  and  re- 


IX]  THE  PROMOTION  OF  PUBLIC  UTILITIES  97 

construction  is  then  obtained  through  the  sale  of  securities  of 
the  new  corporation,  and  the  whole  undertaking  comes  to  the 
investing  public  as  a  new  promotion. 

The  estimates  of  the  profits  to  be  realized  and  the  new 
capital  needed  in  such  cases,  when  carefully  made  by  engineers 
experienced  in  the  public  utility  business,  are  often  very 
accurate  and  are  the  most  reliable  offered  to  the  investor  in  any 
form  of  promotion.  Great  care  must  be  exercised,  however, 
that  estimates  be  not  overstated.  A  reputation  for  conserv- 
atism in  his  estimates  is  of  great  value  to  any  such  promoter 
who  seeks  aid  from  bankers. 

Money  Investment  Required. — Of  great  importance,  too, 
in  determing  the  banker's  indorsement  and  the  form  of  the 
financial  plan,  is  the  money  investment  required  to  acquire 
and  develop  the  property.  As  stated  before,  the  majority  of 
small  gas  and  electric  light  companies  were  built  by  local  busi- 
ness men  and  their  promotion  follows  no  ordinary  lines.  They 
are  purely  local  enterprises  in  m.anagement  and  ownership.  It 
is  only  when  these  local  enterprises  are  acquired  by  outside 
interests  and  the  capital  for  them  shifts  into  regular  invest- 
ment channels  that  they  assume  importance  from  the  point  of 
view  of  general  finance.  These  local,  unprogressive,  and  quite 
often  unprofitable  enterprises  must  be  paid  for  by  bankers  who 
undertake  the  financing  of  the  promotion.  Fixing  the  pur- 
chase price  is  one  of  the  objects  of  the  negotiations  undertaken 
by  the  promoters.  Once  this  price  is  agreed  upon,  it  becomes 
an  ever-present  element  in  determining  the  character  and  the 
amount  of  the  new  securities  to  be  issued. 

In  spite  of  the  inexactitude  and  dififerences  of  method  in 
the  physical  valuation  of  water,  gas,  and  electric  companies, 
there  is  surprising  uniformity  in  the  judgment  of  values  made 
by  buyers  of  public  utility  properties.  Their  price  is  not  a 
matter  of  physical  valuation,  but  of  earnings  and  "possibilities," 


98  CORPORATION  FINANCE  ( IX 

as  the  future  opportunities  for  development  are  called.  If  the 
territory  is  developed  to  such  an  extent  that  the  company  has 
about  as  many  customers  as  the  population  would  war- 
rant, and  the  equipment  is  in  fair  condition,  neither  new 
nor  so  antiquated  as  to  be  useless,  one  may  say  roughly  that 
the  price  promoters  are  willing  to  pay  is  ten  times  the  net 
earnings.  That  is,  given  a  small  local  company  operating 
under  average  conditions,  a  typical  case,  outside  bankers  and 
engineers  will  be  willing  to  purchase  the  property  for  an 
amount  equal  approximately  to  ten  times  its  normal  earning 
capacity.  This  is  spoken  of  as  a  "lo  per  cent  basis,"  meaning 
that  the  capital  value  is  such  that  the  earnings  are  lo  per  cent 
of  it.  However,  within  recent  years  both  bankers  and  pro- 
moters have  been  forced  to  recognize  that,  for  the  purpose  of 
estimating  future  earnings,  the  value  of  a  public  utility  is  no 
greater  than  that  allowed  by  rate-making  commissions.  A 
recent  report  of  the  Committee  on  Public  Service  Corpora- 
tions of  the  Investment  Bankers  Association  states  that  com- 
missions have  usually  reached  the  conclusion  that  a  public 
utility  should  earn  about  one-twelfth  of  its  value  each  year. 

Such  simple  values  are,  however,  subject  to  certain 
modifications,  the  most  important  of  which  is  the  economic 
background  of  the  community  served  by  the  utility.  Attention 
has  been  drawn  already  to  the  fact  that  communities  may  be 
arranged  in  a  kind  of  economic  life  cycle,  from  the  ascending 
vigor  of  youth  to  the  descending  decay  of  old  age.  Wires 
and  mains  are  worth  little  in  a  community  of  vacant  houses, 
closed  factories,  and  abandoned  farms.  On  the  other  hand. 
the  mere  privilege  of  doing  business,  attested  by  an  antiquated 
and  dilapidated  plant,  may  be  worth  a  large  amount  although 
the  accounts  show  an  operating  deficit. 

Economic  Stability. — The  banker  will  be  influenced,  too, 
by  the  economic  background   of   the   community.     A   large 


IX  ]  THE  PROMOTION  OF  PUBLIC  UTILITIES  99 

manufacturing  industry  very  much  improves  the  economic 
stability  of  the  region;  but  in  a  "single-industry"  town  the 
prosperity  fluctuates  too  much  with  the  prosperity  of  the  in- 
dustry. A  group  of  small  diversified  manufacturing  industries 
employing  highly  skilled  men  affords  the  best  possible  field 
for  the  local  utility.  Generally  speaking,  the  nearer  the  indus- 
tries are  to  the  basic  process  of  manufacture — in  the  sense 
that  the  furnace  man  is  basic  to  the  steelmaker,  and  the  steel- 
maker to  the  bridge-builder — the  stronger  will  be  the  economic 
stability  of  the  locality.  If  the  industries  are  directly  connected 
with  some  monopolistic  source  of  raw  material,  as  Duluth- 
Superior  is  allied  with  the  Lake  Superior  iron  mines,  the 
prosperity  of  the  town  must  be  judged  in  terms  of  the 
prosperity  of  its  fundamental  industry.  All  things  considered, 
the  community  with  a  wide  diversity  of  manufacturing  indus- 
tries, surrounded  by  a  considerable  area  of  diversified  farm- 
ing lands,  shows  the  highest  degree  of  economic  stability. 
And  the  accuracy  and  reliability  of  bankers'  predictions  of 
future  earnings  will  depend  upon  this  economic  stability. 

The  Financial  Plan. — Granting  that  the  local  utility  or 
group  of  utilities  will  cost  the  promoter-engineer  ten  times  the 
net  earnings  of  the  previous  year,  and  that  his  estimates  of 
future  earnings  are  sufficiently  sound  to  interest  his  banker  in 
the  enterprise,  the  next  step  to  consider  is  the  financial  plan, 
which  the  two  will  formulate  together.  The  new  corporation 
will  take  over  the  physical  property,  franchises,  and  privileges 
of  the  old  utilities.  Two  limiting  considerations  will  deter- 
mine the  proportion  of  bonds  and  stocks  to  be  issued  and  their 
absolute  amounts — the  ease  with  which  the  banker  can  sell 
the  securities  to  the  public,  and  the  actual  amount  of  money 
that  must  be  raised — for  the  banker  is  confronted  with  the 
stern  necessity  of  selling  the  securities  in  competition  with 
those  of  other  bankers  and  they  must  be  attractive. 


100  CORPORATION  FINANCE  [IX 

The  first  matter  to  be  considered  is  the  kind  of  securities, 
the  second  their  relative  and  absolute  amount.  Public  utilities 
differ  among  themselves  in  the  extent  to  which  their  earnings 
are  affected  by  general  business  conditions.  The  relative  con- 
stancy is  inverse  to  the  elasticity  of  the  demand  for  the  com- 
modity supplied.  Water  company  earnings  are  least  fluctuating, 
then  gas,  then  steam  electric,  and  finally  those  of  hydroelectric 
developments  with  a  considerable  power  load.  But  the  earn- 
ings of  public  utility  enterprises  are  on  the  whole  remarkably 
constant,  neither  abnormally  high  in  times  of  business  "boom" 
nor  abnormally  low  in  times  of  business  depression.  There 
is  therefore  no  reason  to  fear  that  a  reasonable  load  of  fixed 
charges  will  precipitate  bankruptcy.  This  being  true  it  will 
be  expedient  to  issue  at  the  outset  a  certain  amount  of  bonds, 
since  a  part  of  the  money  may  be  secured  more  cheaply 
through  bonds  than  through  the  sale  of  stocks  alone.  In 
accordance  with  the  investment  habits  and  prejudices  of  the 
period  immediately  before  the  Great  War — which  we  may 
consider  normal — a  high-grade  first  mortgage  public  utility 
bond  would  be  bought  by  the  investor  at  a  price  to  yield  him 
between  5  and  5>4  per  cent,  whereas  he  would  not  buy  a 
high-grade  preferred  stock  of  a  new  company  on  less  than  a 
6^  or  7  per  cent  investment  return. 

Amount  of  Bonds  Issued. — If  the  bonds  are  to  be  issued 
the  amount  must  be  small;  the  interest  upon  them  must  be 
only  a  moderate  proportion  of  the  past  earnings  or  of  the 
prospective  future  earnings.  While  there  is  no  invariable 
principle,  the  conservative  banker  in  protecting  his  customers 
will  insist  that  the  interest  charges  on  the  bonds  proposed  by 
the  financial  plan  shall  be  not  more  than  one-half  the  amount 
of  the  current  net  earnings  after  making  reasonable  allowance 
for  depreciation  and  obsolescence.  Such  bonds  he  can  sell 
without  much  difficulty,  provided  the  general  bond  market  is 


IX]  THE  PROMOTION  OP  PUBLIC  UTILITIES  lOI 

favorable,  and  provided  he  can  conscientiously  recommend 
them  to  conservative  investors.  And  the  observance  of  this 
principle  is  wise  financial  practice  on  the  part  of  the  promoters 
of  the  new^  enterprise,  for  it  would  be  distinctly  inexpedient 
for  the  corporation  to  assume  a  fixed  bond  interest  charge 
of  more  than  half  its  assured  earning  capacity. 

Granting  that  the  old  companies  were  bought  on  a  "lo 
per  cent  basis,"  it  is  clear  that,  were  it  possible  for  the  company 
to  realize  the  par  value  of  5  per  cent  bonds,  exactly  enough 
money  would  be  supplied  to  pay  for  the  old  properties.  But 
the  par  value  of  5  per  cent  bonds  cannot  be  realized ;  the  in- 
vestor will  not  ordinarily  pay  100  for  the  5  per  cent  bonds  of 
a  new  utility,  the  banker  must  have  a  profit  for  the  sale  of 
the  bonds,  and  the  new  company  must  be  provided  with  money 
to  pay  for  the  improvements  and  extensions  necessary  to 
rehabilitate  the  old  plants.  For  such  things,  other  securities 
inferior  in  character  must  be  sold  to  supply  the  additional 
money.  These  may  be  short-time  notes,  shares  of  preferred 
stock,  or  even  common  stock. 

Notes  and  Preferred  Stocks. — As  a  general  rule,  notes 
should  not  be  issued  at  the  time  of  a  public  utility  promotion. 
They  must  be  refunded  into  bonds  or  stocks  within  a  short 
time.  Unlike  a  manufacturing  business,  the  assets  of  a  public 
utility  are  almost  entirely  fixed  and  not  readily  available  for 
meeting  a  rapidly  maturing  debt.  In  unusual  cases  when  the 
company  has  been  so  ill-managed  during  the  preceding  year  that 
the  past  earnings  give  little  indication  of  what  can  be  accom- 
plished by  the  aid  of  efficient  engineers,  it  may  be  wise  to  issue 
2-  or  3-year  notes.  If  that  is  done  no  preferred  stock  need  be 
sold  until  the  net  earnings  shall  have  so  improved  as  to  enable 
the  company  to  sell  it  for  a  fair  price.  Such  note  issues  are,  in 
efifect,  merely  temporary  financial  expedients  and  should  be 
employed  only  when  there  is  a  reasonable  certainty  that  the 


102  CORPORATION  FINANCE  I IX 

net  earnings  will  be  increased  immediately  by  leaps  and  bounds. 
As  few  newly  promoted  companies  can  be  assumed  to  develop 
greatly  increased  earning  capacity  immediately,  the  issue 
of  preferred  stock  should  be  the  almost  universal  rule,  and 
the  issue  of  notes  the  rare  exception. 

The  preferred  stock  of  a  new  public  utility  that  has  been 
preceded  by  a  senior  issue  of  bonds  will  be  offered  by  the 
banker  as  a  kind  of  "conservative  speculation."  It  should 
appeal  to  that  class  of  investors  only  who,  either  from  ignor- 
rance  or  well-reasoned  judgment — it  is  often  difficult  to  say 
which — are  tempted  to  sacrifice  safety  for  the  promise  of 
large  returns.  The  promised  dividend  must  be  made  high 
to  attract  this  class.  Custom  fixed  it  before  the  Great  War 
at  either  6  or  7  per  cent,  according  to  the  standing  of  the 
interests  behind  the  promotion  or  the  geographical  location 
of  the  public  utility  company ;  the  financial  plan  must  conform 
to  this  custom.  To  sell  the  preferred  shares  to  even  the 
speculative  investor,  the  margin  available,  after  the  deduction 
of  bond  interest  from  the  current  earnings,  from  which  to 
pay  the  dividends,  must  be  at  least  twice  the  dividend  require- 
ments; that  is,  to  phrase  it  a  little  differently,  an  issue  of 
preferred  stock  following  a  prior  issue  of  bonds  must  be 
limited  to  such  an  amount  that  the  promised  dividend  upon 
it  shall  be  no  more  than  half  the  margin  of  net  earnings  left 
after  the  deduction  of  the  bond  interest.  The  issue  of  pre- 
ferred stock  beyond  this  amount  is  not  sound  finance,  but  if 
the  old  properties  entering  into  the  new  company  have  been 
acquired  at  reasonable  prices  and  are  not  too  dilapidated  or 
obsolete  the  sale  of  this  amount  of  preferred  stock  will  be 
ample  to  absorb  the  discount  on  the  bonds  and  supply  the 
company  with  money  for  the  improvements  of  the  first  year. 

Issue  of  Common  Stock. — As  in  the  case  of  manufacturing 
companies,  there  is  no  principle  governing  the  issue  of  common 


IX  1  THE  PROMOTION  OF  PUBLIC  UTILITIES  103 

Stock,  Other  than  that  the  financial  plan  should  appear  well 
balanced.  Most  or  all  of  such  stock  passes  directly  to  the 
promoters,  underwriters,  and  bankers,  as  the  profit  of  the 
promotion.  The  total  amount,  therefore,  is  merely  an  arbitrary 
matter  of  bookkeeping,  having  but  slight  influence  on  the 
future  success  of  the  company.  Even  the  question  of  keeping 
the  control  of  the  majority  of  voting  shares  in  order  to  control 
the  management  will  not  be  vital.  The  public  to  whom  such 
securities  appeal  has  no  inclination  to  interfere  with  a  success- 
ful and  experienced  management  which  is,  apparently,  working 
for  the  best  interest  of  the  common  shareholder. 

Bankers'  Commissions. — As  the  risk  in  the  enterprise  is 
less,  so  the  commission  exacted  by  the  banking  house  will  be 
less  than  with  manufacturing  companies.  The  following 
table  compiled  from  a  study  of  actual  sales  in  the  period  before 
the  Great  War  shows  the  rating  of  the  risk  and  the  commis- 
sions or  gross  profit  obtained  by  bankers  directly  from  the 
sale  of  public  utility  promotion  securities  directly  to  the  public. 

Gross 
Profit  in  Dol- 
lars per  $1,000 
Number  Bond  or  Par 

of  Cases        Value  of  Stock 
New  closed   or   very   carefully   restricted 
gas  and  electric  light  operating  company 
bonds     (distinctly     the    best     of     their 

class)     16  $53.65 

Refunding  and  new  large  open-end  issues 
of  public  service  holding  companies 
(medium   and   low-grade    public    utility 

bonds)    12  67.80 

Preferred  stocks  of  gas  and  electric  light 

operating  companies  16  76.3S 

Preferred  stocks  of  public  service  hold- 
ing companies  (initial  issues  when  it 
is  possible  either  to  eliminate  or  evaluate 
the  common  stock  bonus )    9  93.50 


104  CORPORATION  FINANCE  [IX 

Human  Factors  in  Promotion. — Any  summary  statements 
of  customary  and  standard  methods  of  promoting  a  new  public 
utility,  or  for  that  matter  a  manufacturing  plant  or  a  railroad, 
such  as  this  chapter  presents,  leaves  out  of  account  the  element 
of  the  human  equation.  This  delays,  complicates,  clogs,  and 
racks  the  proceedings  attending  the  birth  of  any  corpora- 
tion. Every  promotion  will  have  strong  dramatic  moments. 
Men  are  playing  against  each  other  for  large  stakes,  and 
the  players  are  usually  men  of  dominating  personalities  and 
unyielding  wills.  Often  the  long  and  otherwise  monotonous 
course  of  the  negotiations  leading  up  to  the  final  plan  of 
promotion  is  one  continuous  conflict  of  human  emotions, 
passions,  and  ambitions — not  always  based  on  economic 
growth,  for  men  will  make  large  pecuniary  sacrifices  in  order 
to  defeat  the  purposes  of  another  or  pamper  some  motive  of 
personal  pride  or  vanity. 

The  account  appended  here  is  not  fiction  but  on  the  con- 
trary an  accurate  report  of  an  actual  promotion,  except  that 
names  and  unimportant  details  are  altered  to  prevent 
identification. 

Through  a  curb  broker,  a  man  by  the  name  of  Richards 
was  introduced  to  two  promoters,  Roe  and  Doe,  who  had 
acquired  through  the  payment  of  a  sum  of  money,  two-thirds 
of  it  borrowed,  the  "contract  of  sale"  of  a  public  utility  in  a 
thriving  eastern  industrial  city.  The  price  called  for  was 
$800,000,  and  in  addition  $300,000  had  to  be  raised  at  the 
same  time  for  the  construction  of  a  new  central  power  station, 
as  the  old  station  was  obsolete  beyond  rejuvenation. 

The  curb  broker.  Roe,  and  Doe,  then  went  through  the 
preliminary  forms  of  organizing  a  corporation  with  $2,000,000 
bonds  and  $2,000,000  common  stock.  The  curb  broker  had 
arranged  with  Roe  and  Doe,  by  a  verbal  understanding,  to 
find  investment  bankers  who  would  supply  the  money  through 
the  purchase  of  bonds  and  a  relatively  small  stock  bonus.     The 


IX  ]  THE  PROMOTION  OF  PUBLIC  UTILITIES  I05 

curb  broker  was  to  receive  2  per  cent  commission  on  the  bonds 
issued  and  $60,000  par  value  in  common  stock.  Richards 
introduced  Roe  and  Doe  to  Smith  and  Peters,  investment 
bankers.  The  curb  broker  had  nothing  further  to  do  with 
the  promotion,  the  negotiations  taking  place  between  the  pro- 
moters and  the  bankers,  with  Richards  acting  as  the  ostensible 
intermediary,  but  actually  as  the  accredited  representative  of 
the  bankers. 

The  following  were  the  successive  plans : 

1.  July  27.  Proposed  by  promoters:  Bonds,  $1,400,000, 
to  be  bought  by  bankers  at  85 ;  common  stock,  $2,000,000 — • 
bankers  to  have  $400,000,  the  remainder  to  promoters;  re- 
fused categorically  by  bankers. 

2.  August  17.  Proposed  by  promoters  :  Bonds,  $1,000,000 
to  be  bought  by  bankers  at  85 ;  preferred  stock,  $400,000,  to 
be  taken  by  promoters  at  80;  common  stock,  $2,000,000,  to 
be  divided  as  follows:  $1,000,000  to  promoters,  $400,000 
bonus  to  public  buyers  of  preferred  stock,  $200,000  bonus 
to  certain  other  unnamed  parties  who  had  advanced  money  to 
promoters,  $400,000  bonus  to  bankers;  refused  by  bankers 
with  the  comment  that  they  "were  interested." 

3.  August  24.  Richards,  Smith,  and  Peters,  and  an  expert 
engineer  visited  the  properties  with  Roe  and  Doe.  Bankers 
stated  to  promoters  that  they  would  "go  into"  the  proposition 
provided:  (a)  the  conditions  of  incorporation  and  mortgage 
lien  were  satisfactory;  (b)  only  $680,000  of  bonds  to  be  issued 
in  the  first  instance;  (c)  bankers  receive  reasonable  allotment 
of  common  stock;  (d)  promoters  assume  responsibility  for 
sale  of  preferred  stock.  These  tentative  terms  accepted  by 
promoters. 

4.  September  2.  Proposed  by  bankers  :  Bonds,  $800,000, 
to  be  bought  by  bankers  at  83 ;  preferred  stock,  $400,000,  to 
be  bought  by  promoters  at  par ;  common  stock,  $2,000,000,  to 
be  divided  as  follows :  $400,000  bonus  to  public  buyers  of 


I06  CORPORATION  FINANCE  [IX 

preferred  stock,  $200,000  commissions  to  various  parties,  in- 
cluding bankers  and  attorneys,  $700,000  to  promoters, 
$700,000  to  bankers ;  refused  by  promoters. 

5.  September  4.  Smith,  Ricliards,  and  the  promoters  meet 
in  a  New  York  hotel  and  effect  the  following  compromise 
agreement:  Notes  for  $320,000;  bankers  agreed  to  secure 
loans  on  these  notes  on  behalf  of  company,  but  payment  of 
these  loans  to  be  guaranteed  to  bankers  by  promoters.  Bonds, 
$800,000,  but  there  was  to  be  issued  and  bought  by  the  bankers 
at  83  only  enough  to  provide,  with  the  proceeds  of  the  loans 
and  preferred  stock  sale,  the  $1,100,000  required  to  pay  for 
the  plant  and  new  power  station.  Preferred  stock,  $400,000, 
to  be  bought  by  promoters  at  83.  The  proceeds  of  the  loans 
and  the  sale  of  sufficient  of  the  bonds  and  all  the  preferred 
stock  to  be  paid  in  immediately  to  complete  payment  for  prop- 
erty. Common  stock,  $2,200,000,  to  be  divided  as  follows: 
$200,000  commissions  to  various  parties,  including  bankers 
and  attorneys;  $900,000  to  bankers;  $1,100,000  to  promoters. 

6.  September  15.  Promoters  inform  bankers  that  they 
cannot  feel  sure  that  they  can  have  the  proceeds  of  the  sale  of 
the  preferred  stock  ready  to  pay  down  at  the  time  the  bankers' 
money  is  available  to  take  over  the  property.  As  promoters 
had  signed  previous  agreement  A  [(5),  September  4],  it  was 
a  virtual  repudiation  of  their  contract.  Bankers  then  say 
that  plan  must  be  readjusted.  Bankers  propose  that  afternoon 
the  following  plan,  which  is  accepted  by  promoters  tentatively : 
Bonds,  $680,000,  to  be  sold  to  bankers  at  86,  less  commission 
of  3  per  cent.  Notes,  $265,600;  note  of  company  to  be  nego- 
tiated and  indorsed  by  bankers.  Preferred  stock,  $400,000, 
divided  as  follows :  $200,000  to  the  promoters,  to  be  paid 
for  at  83,  at  the  time  of  the  formation  of  the  company; 
$200,000  to  be  used  as  collateral  by  promoters  under  a 
guaranty  to  bankers  or  company  that  promoters  buy  and  pay 
for  it  outright  within  30  days.     Common  stock,  $2,200,000, 


IX]  THE  PROMOTION  OP  PUBLIC  UTILITIES  107 

to  be  divided  as  follows:  $200,000  commissions,  $1,000,000 
to  bankers,  $1,000,000  to  promoters. 

7.  September  21.  Promoters  state  that  they  will  not  sell 
preferred  stock.  Bankers  then  insist  on  readjustment  of  plan. 
They  propose  new  plan  which  is  accepted  by  promoters,  and  a 
formal  agreement  is  drawn  up.  Bonds,  $680,000,  to  be  bought 
by  bankers  at  86  per  cent,  less  commission  of  3  per  cent,  in 
the  form  of  company  notes.  Notes  of  $265,600  negotiated 
by  bankers.  Preferred  stock,  $400,000,  to  be  divided  as 
follows:  $188,000  taken  by  promoters  at  83;  $212,000  used 
by  bankers  as  collateral  for  loans,  but  under  guaranty  that 
promoters  will  sell  stock  at  85  in  30  days.  Common  stock, 
$2,200,000,  divided  as  follows:  $180,000  commission  to 
bankers,  attorneys,  etc. ;  $400,000  fund  to  be  used  as  bonuses 
in  selling  other  securities  of  company;  $410,000  to  promoters 
immediately;  $240,000  to  promoters  after  selling  remainder 
of  preferred  stock;  $870,000  to  bankers. 

October  3.  Promoters  repudiate  plan,  after  they  have 
analyzed  it  and  come  to  realize  that  control  passes  to  bankers. 
Promoters  become  very  angry,  as  they  begin  to  realize  that 
Smith  and  Peters  will  not  furnish  the  money  and  take  the  risk, 
while  they,  the  promoters,  reap  the  major  part  of  the  profits. 
A  heated  meeting  occurs  at  which  Roe  accuses  Richards  of 
plotting  to  rob  him  of  the  property.  Roe  calls  Richards  a 
"d black-whiskered  Jew!" 

Roe  and  Doe  begin  negotiations  with  other  bankers,  not- 
withstanding their  agreement  of  September  21  with  Smith 
and  Peters. 

October  9.  Smith  and  Peters  hear  indirectly  of  these  other 
negotiations  and,  through  questioning  of  Doe,  learn  the  details. 

October  1 1 .  Smith  and  Peters  telegraph  the  other  bankers 
that  Roe  and  Doe  have  a  contract  with  them  for  the  promotion 
of  the  project,  and  that  if  the  other  bankers  interfere.  Smith 
and  Peters  will  hold  them  liable  for  breach  of  the  contract. 


I08  CORPORATION  FINANCE  [IX 

Roe,  who  is  shown  the  telegram,  flies  into  a  rage  and  the 
other  bankers  withdraw. 

October  13.  Roe  accuses  Doe  of  playing  false  in  allowing 
Smith  and  Peters  to  discover  Roe's  double  dealing.  The  two 
exchange  heated  accusations,  and  Doe  says  he  is  going  to 
withdraw  from  the  whole  promotion  if  he  can  get  back  the 
money  he  has  put  in.  (Roe  had  put  in  $40,000  of  borrowed 
money — nothing  of  his  own — and  Doe,  $20,000  of  his  own 
money  as  partial  payments  on  the  property.  Doe  had  also 
paid  preliminary  expenses  to  the  amount  of  $12,000.) 

October  15.  Doe  tells  Smith  and  Peters  that  he  is  "sick 
of  the  whole  thing"  and  suggests  that  Smith  and  Peters  buy 
out  the  interest  of  the  promoters  and  take  over  the  whole 
enterprise  themselves. 

8.  October  17.  Promoters  offer  to  sell  their  interests  in 
the  project,  on  which  they  had  $60,000,  to  the  bankers  for 
$90,000.     Bankers  refuse. 

October  17  (Later  in  day).  Bankers  intimate  that  they 
will  accept  responsibility  for  the  promotion  and  buy  interest 
of  promoters,  provided  latter  will  take  part  payment  in 
securities.  Promoters  forced  to  admit  that  their  direct  invest- 
ment is  only  $60,000,  of  which  $40,000  was  borrowed  on  the 
promise  that  it  would  be  returned  immediately  on  consumma- 
tion of  promotion.  Lender  was  to  receive  in  addition  a 
common  stock  bonus.  (One  of  the  unnamed  parties  men- 
tioned under  plan  two,  August  17.) 

9.  October  19.  Bankers,  after  consultation  with  two 
associates,  who  agree  to  participate  with  them  in  the  under- 
taking, make  the  following  offer :  They  will  organize  a  com«^ 
pany  with  the  following  capitalization  : 

Bonds $   680,000  5%  First  mortgage 

Notes 440,000  6%  Second  mortgage 

Preferred  stock 240,000  6%  Cumulative 

Common  stock 1,100,000 


IX]  THE  PROMOTION  OF  PUBLIC  UTILITIES  109 

They  agree  to  assume  the  original  contract  and  pay  the  balance 
of  $740,000  (the  promoters  had,  as  stated  above,  paid  down 
$60,000,  of  which  $40,000  was  borrowed  by  Roe  and  $20,000 
furnished  by  Doe)  and  raise  the  $300,000  necessary  for  the 
construction  of  the  new  plant.  They  offered  Roe  $40,000  in 
money  to  enable  him  to  make  restitution,  and  $50,000  in  com- 
mon stock,  out  of  which  he  must  settle  with  the  party  from 
whom  he  borrowed  on  the  promise  of  a  common  stock  bonus. 
They  offered  Doe  $20,000  in  money  to  reimburse  him 
for  the  money  he  had  advanced  on  the  purchase  contract, 
$12,000  in  the  6  per  cent  notes  of  the  new  company  to  repay 
him  for  his  expenses,  and  $50,000  in  common  stock.  The 
bankers  also  agreed  to  settle  with  the  attorney  of  the  promoters 
and  their  general  utility  man  by  the  payment  of  $8,000  in 
6  per  cent  notes  of  the  new  company,  and  $40,000  in  common 
stock.  Bankers  gave  the  promoters  until  12  midnight  the 
following  day  to  accept  or  reject  the  proposition. 

Doe  accepted  immediately. 

Roe  accepted,  after  numerous  plays  and  counterplays,  five 
minutes  before  midnight. 

As  an  aftermath,  Roe  threatened  to  shoot  Richards,  whom 
he  blamed  for  aiding  and  abetting  the  bankers. 

November  10.  The  curb  broker  threatened  to  bring  suit 
against  Smith  and  Peters  for  a  commission.  Smith  and 
Peters  told  them  to  go  ahead.  (Suit  was  not  brought  because 
the  curb  broker  had  quarreled  with  his  partner,  necessarily 
a  party  in  the  suit,  over  a  woman  stenographer.)  They 
could  have  probably  maintained  a  suit  against  Roe  and  Doe, 
for  whom  they  were  acting  in  bringing  Richards  into  the 
matter,  but  they  recognized  that,  even  if  successful,  they  could 
recover  nothing. 


CHAPTER  X 

THE  UNDERWRITING  SYNDICATE 

The  Syndicate  and  Distribution  of  Securities. — In  these 
various  discussions  of  different  types  of  promotions,  the  abihty 
of  the  banker  to  distribute  the  securities  of  the  new  enterprise 
has  been  assumed.  It  seemed  simpler  from  the  point  of  view 
of  exposition  to  consider  the  steps  leading  to  the  promotion  of 
the  corporation  as  distinct  from  the  selling  of  its  securities,  yet 
in  reality  the  two  are  closely  allied.  No  banker  will  waste  his 
time  or  energy  over  a  plan  of  promotion  unless  he  feels  that  he 
can  sell  its  stocks  and  bonds.  And  the  possibility  of  marketing 
the  security  is  almost  the  first  question  he  must  settle  in  his  own 
mind  before  entering  into  negotiation  with  the  promoter  of  a 
new  project.  Nevertheless  the  machinery  by  which  all  securi- 
ties, whether  stocks  or  bonds,  whether  the  securities  of  new  or 
old  enterprises,  whether  those  of  industrials,  railroads,  or  public 
utilities,  are  sold  is  so  essentially  the  same  that  merely  from  the 
standpoint  of  clearness,  it  seemed  wise  to  treat  of  the  whole 
subject  of  syndicate  underwriting  separately. 

The  general  work  of  the  bond  house  in  catering  to  the  needs 
and  whims  of  the  public  investor  has  been  described  briefly  in 
the  closing  sections  of  the  chapter  on  the  work  of  the  banker. 
But  intermediate  between  the  actual  purchase  of  securities  by 
the  investment  banker  and  their  sale  to  the  public  there  stands 
a  very  important  cog  in  the  machinery.  It  is  the  underwriting 
syndicate.  It  is  used  in  the  distribution  of  all  types  of  securi- 
ties, high  and  low  grade,  and  in  the  distribution  of  the  issues  of 
old  well-established  enterprises  quite  as  much  as  those  of  pro- 
motion projects. 

No  one  banker  will  care  to  assume  the  risk  of  buying  and 


X  ]  THE  UNDERWRITING  SYNDICATE  1 1 1 

selling  an  entire  issue  of  securities,  whatsoever  the  nature  of 
the  enterprise.  Aside  from  a  reasonable  desire  to  distribute  his 
capital  and  the  risks  of  his  business  in  many  directions,  his  own 
customers  possess  only  a  limited  capacity  to  buy  any  one  issue 
of  bonds  or  stocks.  He  must  have  many  different  issues 
to  meet  their  varied  needs,  but  not  too  much  of  any  one 
issue.  Accordingly  he  secures  the  co-operation  of  other 
bankers  who  agree  to  share  with  him  the  risks,  and  very 
often  the  selling,  of  the  securities  he  contracts  to  buy  from 
the  corporation. 

Introduction  into  the  United  States. — The  custom  of 
forming  temporary  associations  for  the  sale  of  securities  was 
introduced  into  this  country  by  Jay  Cooke  in  1871.  He  was 
then  engaged  in  the  task  of  refunding  United  States  bonds. 
Cooke  had  noted  with  considerable  care  the  operation  of  the 
French  "syndicate"  while  on  a  visit  to  France,  and  conceived 
of  the  use  of  a  similar  instrument  in  distributing  American 
securities  here.  While  used  considerably  during  the  period 
from  1880  to  1890  in  the  sale  of  railroad  bonds,  the  American 
underwriting  syndicate  did  not  occasion  general  note  or  become 
an  important  step  in  financial  procedure  until  the  second  period 
of  industrial  promotions.  This  began  in  1897.  Since  then 
the  underwriting  syndicate  has  been  used  in  large  and  small 
undertakings  in  all  fields  of  promotion.  In  fact,  it  may  be 
said  without  exaggeration  that  there  are  no  promotions  of  any 
considerable  size  and  very  few  sales  of  large  blocks  of  securi- 
ties by  corporations  that  have  not  been  accompanied  by  some 
kind  of  an  underwriting  syndicate. 

Assumption  of  Risk. — The  form  and  structure,  the  legal 
and  moral  responsibility,  and  the  general  operation  of  a  syndi- 
cate organized  in  connection  with  the  sale  of  promotion 
securities  may  difiFer  in  no  wise  from  the  corresponding  char- 


112  CORPORATION  FINANCE  [X 

acteristics  of  one  organized  to  distribute  an  issue  of  bonds  or 
stocks  of  an  old-established  corporation,  though  the  profits 
will  be  greater  in  the  former  case.  The  main  point  is  that 
it  is  a  usual,  but  not  a  necessary,  intermediate  step,  in- 
terpolated between  the  issue  of  securities  by  the  corpora- 
tion and  their  final  absorption  by  investors  and  investment 
institutions. 

As  no  two  underwriting  syndicates  are  of  exactly  the  same 
form  and,  owing  to  the  complex  relationship  of  the  various 
parties  of  the  underwriting  agreement,  a  classification  of  them 
is  exceedingly  difficult.  The  principle  behind  them  all  is  that 
a  group  of  bankers  stand  together  to  assume  the  risks  of 
failure  or  success  and  virtually  insure  against  the  failure  of 
any  issue  of  securities  by  promising  to  take  themselves  at  a 
fixed  price  any  left  over  after  a  general  public  offering.  In 
order  to  make  the  whole  procedure  clear  several  different  types 
of  syndicates  will  be  described. 

Simplest  Form  of  Syndicate. — A  syndicate  for  under- 
writing the  bonds  of  a  small  hydroelectric  promotion  well 
illustrates  perhaps  the  simplest  form.  The  total  actual  cost  of 
river  rights,  flowage  basin,  the  money  construction  cost  of  the 
dam,  and  two  transmission  systems  to  adjacent  cities,  together 
with  the  transforming  and  distribution  systems  in  these  cities, 
was  $1,128,000  in  actual  money. 

This  entire  cost  was  met  by  means  of  the  sale  to  banks 
of  notes  indorsed  by  the  investment  bankers  who  proposed  t(? 
stand  back  of  the  enterprise — we  will  call  them  Smith  an(^ 
Company.  When  the  development  was  finished  and  the  com' 
pany  in  actual  operation  Smith  and  Company  formed  an  under- 
writing syndicate  to  help  carry  the  financial  burden  of  the 
enterprise.  Before  they  did  this,  however,  the  Assinippi 
Electric  Company,  as  the  entire  development  may  be  called, 
issued  the  following  securities : 


XI  THE  UNDERWRITING  SYNDICATE  II3 

Authorized  Issued 

First  mortgage  bonds   (5%) $  3,000,000  $1,000,000 

Preferred  stock   (7%) 1,000,000  437,500 

Common  stock 10,000,000  4,000,000 

Smith  and  Company  then  sent  to  four  of  their  associates 
in  other  cities  an  "offer  of  participation"  in  the  Assinippi 
Electric  Company's  first  mortgage  bond  syndicate.  This  offer 
of  participation  set  forth  in  detail  the  nature  of  the  enterprise, 
its  financial  plan,  and  the  details  of  the  syndicate  operation,  so 
far  as  these  could  be  anticipated.  Each  of  the  four  answered 
that  they  would  accept  a  participation  in  the  syndicate  and 
specified  the  amounts. 

Smith  and  Company  subsequently  sent  to  their  four  asso- 
ciates a  formal  contract  or  participation  agreement.  Such  a 
document  is  known  always  as  the  "syndicate  agreement."  It 
contained,  among  others,  five  provisions  to  be  found  in  all 
syndicate  agreements  of  this  general  character.  There  was, 
first,  a  statement  of  the  purpose  for  which  the  syndicate  was 
organized — in  this  case  the  acquisition  of  the  $1,000,000  of  the 
first  mortgage  bonds  of  the  Assinippi  Electric  Company.  Sec- 
ondly, a  statement  of  the  price  at  which  the  bonds  were  to  be 
acquired  on  syndicate  account — in  this  case  80  per  cent  of  par 
value,  in  addition  to  which  the  syndicate  was  to  receive  $1,000.- 
000  par  value  of  the  common  stock.  Thirdly,  a  clear  statement 
of  the  terms  under  which  Smith  and  Company  were  to  manage 
the  syndicate,  their  compensation  and  the  conditions  under 
which  it  should  be  paid — in  this  case  2  per  cent  for  each  bond 
sold  on  syndicate  account,  provided  a  price  of  85  per  cent  was 
obtained  for  the  bonds.  Fourthly,  a  statement  of  the  condi- 
tions under  which  the  securities  acquired  by  the  syndicate 
should  be  sold — in  this  case  not  less  than  85  per  cent  if  sold 
within  18  months,  and  if  at  the  end  of  that  time  the  bonds 
had  not  been  entirely  distributed  the  manager  agreed  to  secure 
the  consent  of  all  the  underwriters  before  offering  the  bonds 

8 


114  CORPORATION  FINANCE  [X 

at  a  lower  price.  And  lastly,  a  statement  of  the  amount  of 
subscription  or  "underwriting"  assumed  by  each  of  the 
bankers.  In  this  case  the  managers  themselves  participated  to 
the  amount  of  $400,000  of  the  $1,000,000  of  bonds,  another 
banker  to  $100,000,  and  the  other  two  to  $250,000  each,  thus 
completing  the  entire  amount. 

These  five  elements  are  to  be  found  in  every  under- 
writing syndicate  agreement  in  which  the  manager  under- 
takes to  superintend  the  marketing  of  the  securities. 
In  most  instances  also  there  are  numerous  other  stipu- 
lations which  are  peculiar  to  the  circumstances  of  the  un- 
derwriting. The  syndicate  agreement  may  specify  among  other 
things,  whether  or  not  the  participations  may  be  transferred, 
at  what  time  and  under  what  conditions  payments  are  to  be 
made  by  the  participating  members,  whether  or  not  the 
manager  has  the  right  to  buy  and  sell  all  the  syndicate  securi- 
ties or  to  hypothecate  them,  whether  the  syndicate  itself  or 
the  manager  shall  bear  the  direct  expenses  of  the  sale  if  such 
are  incurred,  and  a  host  of  other  details  that  might  lead  to 
dispute.  The  syndicate  members  may  be  large  wholesale  bond 
houses  who  do  not  undertake  to  reach  the  single  investor.  In 
the  case  of  the  Assinippi  bond  syndicate  just  described  the 
managers.  Smith  and  Company,  sold  the  bonds  14  months  later, 
at  883/2,  to  a  "bond  house,"  or  merchandise  investment  banker 
with  many  branch  offices  and  a  large  selling  organization 
designed  to  reach  small  investors.  These  last  paid  94  for  the 
bonds  some  two  months  afterward.  Besides  the  money  profit 
the  syndicate  realized  a  considerable  profit  through  the  ultimate 
disposal  of  its  common  stock  bonus. 

An  Unsuccessful  Syndicate. — Not  all  syndicates  are 
successful,  as  the  following  case  shows.  In  1902,  prominent 
financial  interests  in  New  York  promoted  a  consolidation  of 
real   estate  building  and  owning  companies,   known   as   the 


X]  THE  UNDERWRITING  SYNDICATE  115 

United  States  Realty  and  Construction  Company,  The  pro- 
moters, having  been  impressed  with  the  speculative  enhance- 
ment of  New  York  realty  values,  wished  to  obtain  a  large  fund 
of  ready  money  which  could  be  used  in  building  construction 
and  speculative  ventures.  Some  of  the  best  known  and  ablest 
financiers  of  the  country  were  led  to  lend  their  financial  and 
moral  support  to  the  enterprise.  Mainly  through  the  efforts 
of  James  Stillman,  of  the  National  City  Bank,  a  syndicate  was 
organized  to  supply  $i  1,000,000  in  money  to  the  new  company. 
The  syndicate  received  $11,000,000  in  the  preferred  stock  and 
$11,000,000  in  the  common  stock  of  the  United  States  Realty 
and  Construction  Company  in  return  for  the  money.  Of  the 
$11,000,000  subscribed  by  the  members  of  the  syndicate,  20 
per  cent  was  immediately  paid  in  money,  60  per  cent  was  paid 
by  their  notes,  and  banks  arranged  to  carry  the  remaining  20 
per  cent  in  the  form  of  a  loan,  the  syndicate  securities  being 
used  as  collateral.  So  popular  and,  in  the  past,  so  profitable  had 
the  underwriting  of  new  industrial  promotions  proved  to  be, 
that  the  right  to  subscribe  to  the  syndicate  was  looked  upon  as 
a  privilege.  A  financial  journal  of  New  York  stated  that 
"nearly  every  important  financial  interest  in  this  city"  sub- 
scribed to  the  syndicate.  The  number  included  the  Equitable 
and  New  York  Life  Insurance  companies,  the  National  City 
and  other  prominent  banks  and  trust  companies.  Messrs. 
Hallgarten  and  Company  acted  as  managers,  receiving  for 
their  services  2  per  cent  of  the  total  subscriptions,  or  $220,000. 
Just  a  year  after  its  formation  the  syndicate  was  liquidated. 
During  the  period  of  its  duration  the  manager  had  bought  and 
sold  both  the  preferred  and  common  stocks  of  the  United 
States  Realty  and  Construction  Company  and  had  collected 
approximately  $500,000  in  dividends.  As  a  result  of  these 
operations  the  subscribers  to  the  syndicate  received  for  each 
$1,000  of  original  subscription,  $1,155  V^^  value  in  preferred 
stock,  $702  par  value  in  common  stock,  and  $16.66  in  money. 


Il6  CORPORATION  FINANCE  [X 

These  securities  had,  on  the  day  the  syndicate  was  liquidated, 
a  value,  including  the  money,  of  $523.09  for  each  $1,000 
original  subscription,  or  approximately  one-half  what  had  been 
subscribed  the  year  before.  If  the  interest  on  the  subscription 
should  be  deducted,  the  returns  to  the  members  of  the  syndi- 
cate were  actually  less  than  one-half  the  original  subscription. 

"Selling  Syndicates." — In  another  type  of  syndicate  the 
entire  work  of  selling  is  assumed  by  the  participating  sub- 
scribers themselves.  This  is  the  usual  means  of  distributing 
small  issues  among  investment  banking  houses,  each  one  of 
whom  is  expected  to  exert  itself  in  selling  the  securities  among 
its  own  clients.  And  it  is  from  membership  in  these  "selling 
syndicates,"  as  they  are  sometimes  called,  that  the  small  in- 
vestment bankers  all  over  the  country  get  the  securities  they 
ofifer  their  customers.^ 

In  detail,  this  type  is  excellently  illustrated  by  the  bond- 
selling  syndicate  of  the  Western  Light  and  Power  Company. 
This  company  was  the  result  of  a  reorganization  of  the  old 
Northern  Colorado  Power  Company  in  which  the  Westing- 
house  interests  had  a  considerable  amount  of  money  tied  up. 
The  reorganized  company  issued  $2,100,000  first  mortgage 


'  The  following  letter  is  a  typical  form  of  an  "offer  of  participation"  sent  by 
the  wholesaler,  who  acts  as  the  syndicate  manager,  to  small  dealers  all  over  the 
country: 

Confidential 

MONONGAHELA    VaLLEY    TrACTION    CoMPANY 

General  Mortgage  7  Per  cent  Five-Year  Gold  Bonds 

New   York,   August   30,    1918. 
Messrs.  Hopkins,  Eldridge  &  Company 

Philadelphia,    Penn. 
Dear    Sir: 

We  and  our  associates  are  arranging  the  purchase  of  $5,500,000  Monongahela 
Valley  Traction  Company  General  Mortgage  7  Per  Cent  Five-Year  Gold  Bonds,  dated 
July  I,  1918,  and  due  July  i,  1923,  and  we  are  forming  a  selling  syndicate  in  which  we 
shall  participate,  to  take  over  these  Bonds  at  94  and  accrued  interest,  when,  as 
and  if  issued  and  received  by  us.  It  is  expected  that  definitive  bonds  will  be  ready 
for  delivery  about   September   12th. 

The  list  offering  price  of  these  Bonds,  subject  to  change  at  our  discretion  without 
notice,  shall  be  97  and  accrued  interest.  Syndicate  members  will  be  allowed  a  selling 
commission  ol  lYz  per  cent  of  their  confirmed  sales,  out  of  which  selling  commission  they 
may  allow  ^  of  i  per  cent  to  financial  institutions  and  Y2  of  i  per  cent  to  other  dealers 
and  banks  with  bona  fide  bond  departments.  You  may  begin  offering  bonds  on  Tuesday, 
September  3,   1918. 


X]  THE  UNDERWRITING  SYNDICATE  1 1? 

1 0-year  5  per  cent  bonds  on  May  i,  1915.  No  attempt  was 
made  to  sell  these  bonds  until  the  late  winter,  when  the  bank- 
ing house  of  William  Morris  Imbrie  and  Company  arranged 
and  became  the  managers  of  a  selling  syndicate  organized  to 
distribute  the  bonds  among  investors.  This  syndicate  agree- 
ment, reproduced  in  the  form  of  a  letter,  as  given  below, 
contains  features  unknown  in  syndicate  underwriting  until 
recently.  One  of  the  most  important  of  these  new  features 
was  the  privilege  extended  to  the  participants  to  buy  the 
bonds  outright  of  the  syndicate,  and  extinguish  thereby  their 
liability, 

William  Morris  Imbrie  and  Company 

61   Broadway 
New  York 

$2,100,000 

WESTERN  LIGHT  AND  POWER  COMPANY  FIRST   MORTGAGE  5  PER 
CENT   lO-YEAR  GOLD  BONDS  SYNDICATE 

Gentlemen : 

We  confirm  your  participation  of bonds  in  the  above 

syndicate  at  the  price  of  87  and  interest.  This  syndicate  will  expire 
December  28,  1915,  unless  sooner  terminated  by  ourselves  as  Syndi- 


All  sales  shall  be  subject  to  confirmation  by  us  and  for  syndicate  account. 

Members  sliall  share  pro  rata  in  the  profits  or  losses,  after  allowing  for  syndi- 
cate expenses.  The  syndicate  will  expire  at  the  close  of  business  October  31,  1918, 
unless  sooner  terminated  by  us.  We  reserve  the  right  to  extend  the  syndicate  an 
additional    period   or    periods,    such   extension    not   to   exceed    in    the    aggregate    30    days. 

We  shall  have  sole  direction  of  the  syndicate,  with  full  powers,  and  will  make 
no  charge  for  our  service  in  this  connection,  as  the  price  above  named  includes  a 
profit  to  us.  We  may,  in  our  discretion,  purchase  and  resell  bonds  for  syndicate 
account  in  such  amounts  and  at  such  prices  as  we  may  deem  advisable,  and  should 
any  bonds  remain  unsold  upon  the  termination  of  the  syndicate,  we  may  sell  such 
bonds  upon  such  terms  as  we  deem  advisable,  to  any  person  or  syndicate,  and  we 
may  participate  in  any  such  purchase. 

We  enclose  herewith  several  preliminary  circulars  for  your  use  and  will  provide 
promptly  as  many  more  as  you  may  need,  carrying  your  imprint,   if  you  will  advise  us. 

We  are  pleased  to  offer  you  a  participation  of  $50,000.  This  participation  shall 
not   be  transferred   or   subdivided. 

Kindly  advise  us  of  the  acceptance  of  your  participation  on  the  terms  stated,  by 
wire,  and  confirm  by  letter.  We  reserve  the  right  to  close  the  participation  list  at 
any  time   without  notice. 

Yours   very   truly. 

The  National  City  Company, 

By   H.    B.    Baker, 
Vice-President. 


Il8  CORPORATION  FINANCE  [X 

cate  Managers,  all  the  bonds  having  been  sold.    The  Syndicate  Man- 
agers reserve  the  right  to  extend  the  syndicate  for  sixty  (60)  days. 

The  offering  price  of  the  bonds  will  be  92^^  and  interest.  Syndicate 
members  will  be  allowed  2>4  per  cent  commission  on  sales  made  for 
syndicate  account.  A  commission  of  i  per  cent  may  be  allowed  to 
investment  dealers  or  banks  with  bona  fide  bond  departments,  this 
commission  to  be  a  part  of  the  2^2.  per  cent  commission  allowed  to 
participants.  We  reserve  the  right,  however,  to  sell  large  blocks  at  a 
very  large  concession  from  this  figure,  and  would  be  glad  to  have 
you  advise  us  if  you  have  anyone  interested  in  such  blocks.  Partici- 
pants shall  be  responsible  for  their  numbers  during  the  life  of  the 
syndicate,  and  the  Syndicate  Managers  reserve  the  right  to  make  a 
market  on  the  bid  side  of  91^^  per  cent  during  the  life  of  the 
syndicate. 

Each  syndicate  member  as  he  sells  bonds  for  the  account  of  the 
syndicate  reduces  his  syndicate  liability  to  that  extent.  In  other 
words,  a  participant  will  not  be  called  upon  to  take  up  at  the  termina- 
tion of  the  syndicate  unsold  bonds  to  an  extent  greater  than  the  differ- 
ence between  the  amount  of  his  participation  and  the  bonds  sold  by 
him.  Arrangements  have  been  made  for  the  carrying  of  these  bonds 
during  the  life  of  the  syndicate. 

Definitive  bonds  are  now  ready  for  delivery.  As  soon  as  proof 
circulars  are  received,  a  quantity  of  same  will  be  forwarded  to  you. 
Kindly  advise  us  how  many  circulars  you  will  need  with  your  im- 
print thereon,  and  forward  us  your  imprint  showing  the  way  you 
desire  them  printed. 

General  circularization  will  take  place  on  or  about  Monday  night, 
November  29,  and  the  bonds  will  be  offered  publicly  by  advertisement 
on  or  about  Wednesday,  December  8.  These  dates  are  subject  to 
change,  and  you  will  be  advised  definitely  later  with  reference  to 
them. 

Syndicate  expenses  will  be  ratably  shared  by  the  participants,  but 
in  no  event  will  they  exceed  a  quarter  of  I  per  cent  of  the  par  value 
of  the  bonds  syndicated. 

If  you  care  to  withdraw  your  participation,  you  are  at  liberty  to  do 
so  at  87^,  which  is  the  syndicate  price  plus  %  per  cent  for  syndicate 
commissions.  It  is  understood,  however,  that  in  case  of  withdrawal 
you  will  still  keep  to  all  of  the  selling  terms  of  the  syndicate,  the 
same  as  though  your  bonds  were  being  carried  for  syndicate  accounts. 

Kindly  confirm  your  acceptance  of  the  above  participation,  and 


X]  THE  UNDERWRITING  SYNDICATE  II9 

advise  us  how  many,  if  any,  of  these  bonds  you  wish  to  take  up  at  the 
present  time. 

Yours  very  truly, 

Ofifer  of  participation  in  this  syndicate  was  made  by  the 
following  letter : 

November  28,  19 15. 
Messrs.  Brown,  Green  and  Company, 

New  Orleans,  Lousiana. 
Dear  Sirs: 

As  discussed  with  your  Mr.  Green  over  the  telephone  this  morn- 
ing, we  are  forming  a  syndicate  on  Western  Light  &  Power  First 
Mortgage  5%  Bonds  of  1925,  and  enclose  herewith  a  confidential 
syndicate  memorandum,  together  with  a  copy  of  the  syndicate  agree- 
ment concerning  this  issue.  We  offer  you  a  participation  of  $250,000 
of  this  issue  according  to  the  terms  set  forth  in  the  agreement  en- 
closed herewith,  and  we  might  consider  giving  you  the  exclusive 
southern  territory,  excepting  Messrs.  Jones,  Seagraves  and  Company, 
who  are  already  in  the  business  with  us.  For  an  amount  of  participa- 
tion less  than  the  one  mentioned,  we  would  not  care  to  give  you  the 
exclusive  right  to  offer  this  issue  in  that  section. 

We  wish  to  suggest  in  connection  with  the  terms  mentioned  in  the 
Syndicate  Agreement,  that  in  some  cases  we  have  allowed  participants 
to  withdraw  their  total  allotment  immediately  upon  the  payment  of 
87^  and  interest  for  the  bonds,  thus  being  able  to  immediately  realize 
their  entire  profit.  We  have  added  in  these  cases  to  the  price  of  87 
mentioned  in  the  Agreement  Ya  of  1%,  as  being  a  fair  amount  for 
syndicate  expenses.  We  merely  mention  this  in  passing,  since,  if  you 
are  interested  in  this  business,  it  is  an  item  you  will  undoubtedly  care 
to  know  about. 

You  will  find,  after  reading  the  memorandum  which  we  are  send- 
ing you,  that  we  are  offering  you  a  participation  in  some  business  in 
a  first  mortgage  bond  issue  with  only  gY^  years  to  run,  which  will  be 
retailed  to  the  public  at  92^,  or  a  6.05%  basis,  a  bond  which  is  a 
mortgage  on  a  property  earning  twice  the  interest  requirements,  and 
operated  by  the  Electric  Properties  Company. 

Westinghouse,  Church,  Kerr  and  Company,  well-known  engineers, 
have  made  an  exhaustive  report  on  this  property  for  us,  the  books  and 


120  CORPORATION  FINANCE  [  X 

accounts  have  been  audited  by  Messrs.  Price,  Waterhouse  and  Com- 
pany, and  the  legality  of  the  issue  has  been  passed  upon  by  Messrs. 
Cravath  and  Henderson. 

We  feel  that  a  first  mortgage  bond  earning  over  twice  its  interest 
charges,  which  can  be  offered  to  the  public  on  better  than  a  6%  basis, 
with  a  profit  of  5>4  points  to  the  selling  syndicate,  is  particularly 
attractive  business  from  all  standpoints,  and  we  shall  be  glad  to  have 
you  come  along  with  us.  The  business  is  new,  the  bonds  never  having 
been  offered,  and  we  are  beginning  to  form  our  syndicate. 

We  have  purposely  offered  our  syndicate  participations  in  this 
business  in  the  west  before  approaching  our  New  York  friends,  since 
this  is  a  western  issue,  and  we  are  pleased  to  report  that  we  have 
confirmed  participations  in  Chicago  to  the  Bond  Department  of  one  of 
the  largest  National  Banks,  two  of  the  better  class  of  local  bond  houses, 
and,  in  addition,  two  of  the  large  Trust  Companies  are  actively  nego- 
tiating and  will  undoubtedly  come  in.  We  have  in  Colorado  three  of 
the  best  dealers,  and  we  are  today  negotiating  with  prominent  dealers 
in  Cleveland,  St.  Louis,  and  Milwaukee. 

We  therefore  anticipate  that  this  issue  of  bonds  will  move  rapidly, 
and  request  that  if  it  is  of  interest  to  you,  you  communicate  with  our 

Mr.  over  the  telephone  and  advise  us  as  to  what  interest  you 

may  have  in  the  matter  at  your  early  convenience. 

We  are,  dear  sirs. 

Yours  very  truly, 

Arrangements  for  Carrying  the  Issue. — Incidental  to  the 
assumption  of  risk  is  the  task  of  supplying  money  with  which 
to  carry  the  securities  until  such  time  as  it  is  expedient  to  sell 
them.  Generally,  except  when  the  syndicate  acts  for  large 
corporations  as  an  insurance  medium  only,  its  manager  must 
pay  for  the  securities  before  they  can  be  marketed,  either  wholly 
or  in  part.  A  considerable  sum  of  money  is  usually  tied  up. 
Sometimes  the  corporation  selling  them  will  lend  its  credit, 
sometimes  the  manager  will  use  his  own  credit,  but  much  more 
frequently  the  manager  seeks  to  negotiate  loans  with  a  trust 
company  which  expects  a  "commission,"  or  an  abnormally 
high    rate    of    interest — whichever    way    the    transaction    is 


X]  THE  UNDERWRITING  SYNDICATE  121 

regarded — for  its  help.  These  are  known  as  "syndicate  loans." 
Seldom  is  the  trust  company  willing  to  advance  the  entire 
amount  required  by  the  syndicate  to  complete  its  purchase  of 
securities,  but  through  the  aid  of  these  loans  it  is  frequently 
possible  for  the  manager  to  avoid  tying  up  his  own  funds  or 
those  of  the  participants  to  the  extent  of  more  than  a  quarter 
of  the  total  money  involved. 

In  spite  of  the  difference  in  actual  detail,  all  these  cases 
show  clearly  that  the  assumption  of  the  risks  incident  to  the 
sale  of  securities  is  the  fundamental  and  essential  characteristic 
of  all  underwriting  syndicates.  It  is  their  social  and  economic 
service  as  well.  Participated  in,  for  the  most  part,  by  banking 
houses  controlled  by  men  conversant  with  financial  values,  who 
gauge  more  accurately  than  the  public  the  worth  of  new  enter- 
prises, there  is  less  likelihood  of  industrial  failure  and  waste  of 
public  funds  than  if  the  attempt  were  made  to  distribute  the 
securities  directly  to  the  public. 


CHAPTER  XI 

THE  IMPORTANCE  OF  ACCOUNTING 

Need  for  Science  of  Accounting. — The  big  business  with 
its  several  types  of  obHgations  introduces  more  specific 
problems  of  management  and  financial  policy  than  any  man  or 
group  of  men  can  hold  in  their  minds  at  once,  or  "feel  their 
way  along"  in.  And  when  the  outside  investor  comes  to  ques- 
tion the  wisdom  of  the  managements  under  whose  control  his 
investment  falls  he  needs  to  have  the  relationships  of  income, 
expenditure,  property  and  debts,  and  condition  of  plant  made 
clear  and  exact.  The  managers  of  corporations  need  the  help 
of  exact  figures  to  discriminate  between  different  costs  and 
different  ways  of  marketing  their  products. 

Out  of  such  needs  the  science  of  accounting  has  risen.  You 
cannot  tell  at  a  glance  the  condition  of  a  business  enterprise  as 
you  can  examine  a  building  or  a  gasoline  engine,  because  all 
values  of  a  going  business  must  be  computed  indirectly.  At  the 
time  of  promotion  there  may  have  been  a  correspondence 
between  the  value  and  the  cost  of  the  property  acquired  by  the 
new  corporation,  but  no  sooner  is  the  business  under  way 
than  changes  in  the  value  of  its  property  necessarily  occur. 

Purpose  of  Accountancy. — Accountancy,  in  practice,  seeks 
to  place  a  money  value  on  every  form  of  value  used  in  business. 
It  then  sums  up  the  changes  in  the  aggregate  money  values  of 
any  one  business  involved  in  the  buying  and  selling  of  its  stock 
of  goods,  the  decay  of  its  buildings,  the  growth  in  popularity  of 
its  trade-brands,  the  obsolescence  of  its  machinery,  and  the 
countless  other  changes  which  occur  in  the  ordinary  course  of 
the  operation  of  any  business  enterprise.    The  managers  must 

122 


XI]  THE  IMPORTANCE  OF  ACCOUNTING  1 23 

know  of  these  changes  in  terms  of  the  corresponding  money 
values,  that  they  may  determine  whether  or  not  the  business  is 
a  success  and  at  what  points  are  its  weaknesses  and  its 
strengths.  Investors  must  have  the  facts  and  figures  to  enable 
them  to  go  below  the  immediate  signs  of  prosperity,  such  as 
dividend  payments  and  stock  market  quotations,  to  enable  them 
to  judge  of  the  real  soundness  of  their  investments. 

Business  success  is  shown  by  an  increase  in  money  value. 
This  increase  is  the  profit.  Part  of  the  profit  may  be  with- 
drawn for  the  private  use  of  the  proprietors  and  part  should 
be  retained  in  the  business  as  invested  surplus,  or  specifically 
labeled  as  "reserves."  In  all  this  computation  of  profits  and  the 
amount  to  be  withdrawn  from  the  business,  the  principles 
governing  the  determination  of  the  true  money  equivalent 
of  the  property  values  of  the  business  at  various  times  are  of 
paramount  importance.  These  principles  are  the  science  of 
accountancy,  the  science  of  reducing  the  condition  of  a  busi- 
ness to  the  value  of  what  it  owns  and  what  it  owes. 

The  Balance  Sheet  and  the  Income  Account. — Ac- 
countancy leads  to  two  modes  of  representing  a  business  enter- 
prise. One  is  the  correspondence  between  the  money  value  and 
the  economic  value  of  a  business  at  any  one  moment  of  time. 
It  is  a  statement  of  the  money  equivalent  of  the  business — its 
net  worth.  In  familiar  terms,  it  is  the  balance  sheet.  The  other 
mode  of  representation  is  a  statement  of  the  steps  by  which  the 
money  equivalent  or  balance  sheet  of  a  business  at  one  moment 
,  of  time  is  changed  into  another  money  equivalent  at  a  later 
moment  of  time.  It  is  the  general  income  account,  embodying 
all  the  increases  or  decreases  in  economic  value  sustained  by  the 
business  during  the  time  intervening  between  two  balance  sheets. 

The  balance  sheet  should  express,  so  far  as  figures  permit, 
the  wealth  represented  by  a  business  at  any  one  moment  of 
time.     This  wealth  is  in  various  forms,  representing  not  only 


124  CORPORATION  FINANCE  1X1 

property  actually  in  hand  but  also  the  rights  to  receive  prop- 
erty in  the  hands  of  others  at  the  precise  time  represented 
by  the  balance  sheet.  In  addition,  persons  outside  of  the  busi- 
ness probably  have  rights  against  it,  represented  by  property 
being  used  by  it.  It  is  impossible,  therefore,  to  reduce  the 
wealth  of  a  business  to  a  list  of  pieces  of  property  on  hand, 
for  any  going  business  both  owes  others  and  is  itself  owed 
by  others.  Moreover,  much  money  spent  in  the  past  has  gone 
for  intangible  values,  such  as  patent  rights,  franchises,  trade- 
marks, which  have  a  very  distinct  economic  significance, 
although  these  values  are  not  to  be  counted  and  appraised  with 
the  same  precision  as  pieces  of  material  property.  On  the 
other  hand,  the  business  may  be  called  upon  to  meet  certain 
obligations,  not  yet  due,  but  for  which  it  may  be  liable  in  case 
of  the  default  of  someone  else. 

All  these  intangible  values  and  contingent  liabilities  should 
be  expressed  in  the  balance  sheet,  because  they  are  all  signifi- 
cant in  determining  the  true  wealth  value  represented  by  the 
business  at  the  time.  The  balance  sheet  is  thus  a  summary 
of  the  property  and  rights  actually  held  by  the  business,  and 
those  which  others  hold  against  it.  For  the  sake  of  clearness, 
the  property  rights  owned  by  the  business — its  assets — are 
grouped  together  on  one  side,  and  the  property  rights  held 
against  it — its  liabilities — on  the  other. 

The  general  income  and  expenditure,  or  profits  and  loss 
account,  represents  a  summary  of  the  changes  that  have  oc- 
curred between  the  times  at  which  any  two  balance  sheets  are 
taken.  The  period  is  arbitrary.  The  unit  of  one  year, 
ordinarily  chosen,  is  used  merely  as  a  matter  of  convenience. 

Comparative  Balance  Sheets. — For  the  purposes  of  illustra- 
tion we  will  take  the  accounts  of  an  industrial  company  of 
Aiedium  size.  On  December  31,  1918,  and  on  December  31, 
I919,  the  general  record  of  its  property  owned  and  owed  was : 


XII 


THE  IMPORTANCE  OF  ACCOUNTING 


125 


The  American  Snuff  Company 
(In   even   thousands) 
Property  Owned  1918 

Real  estate,  machinery,  etc.    (that  is,  the 

permanent  property  used  in  its  business 

not    susceptible    to    important    changes 

from  year  to  year) $11,737,000 

Securities  owned  (the  investments  in  other 

companies  or  in  government  or  similar 

bonds)    1,331,000 

Inventories  (the  supplies  of  raw  material, 

semi-finished     products,     and     finished 

products    in   its    storerooms) 4,217,000 

Accounts  and  bills   receivable    (the  open 

accounts,  notes,  and  acceptances  of  the 

customers    to    whom    merchandise    has 

been  sold  but  who  still  owe) 1,527,000 

Cash   993,000 

On  the  other  hand,  ?^9,8os,ooo 

The  Company  Owed  1918 

Bills  and  accounts  payable   (owed  to  its 

creditors  for  merchandise  purchased  but 

not  paid   for) $704,000 

This  was  all  it  actually  owed  to  outside 

parties,  but  at  the  same  time  the  business 

was  responsible  (that  is,  had  to  account 

to  somebody)   for  the  following,  items : 
Dividends  declared  to  be  paid  the  follow- 
ing month  on  the  preferred  stock S9,ooo 

And  on  the  common  stock 330,000 

Set   aside   as    a    reserve    or    safety    fund 

to  be  drawn  on  in  case  of  fire 298,000 

Set   aside    as   a    reserve    or    safety    fund 

to    be   drawn    on    in    order   to    replace 

buildings  or  equipment  when  they  wear 

out  or  become  out  of  date 919,000 

Original     investment     by     the     preferred 

stockholders   3,953,ooo 

Investment  by  the  common  stockholder..  11,000,000 

And     finally    a    kind     of    left-over,     or 

surplus,  into  which  goes  the  profit  or 

the  loss  from  the  year's  business 2,542,000 

$19,805,000 


1919 

$11,811,000 
1,424,000 
4,159,000 

1,582,000 

1,063,000 

$20,039,000 

1919 

$636,000 


59,000 
320,000 

265,000 


1 ,037,000 

3,953,000 
11,000,000 


2,869,000 
$20,039,000 


126  CORPORATION  FINANCE  [XI 

Accordingly  the  amount  of  property  owned  by  the  company 
and  the  amount  it  must  account  for  is  the  same.  Such  a  balanc- 
ing of  the  two  is  called  a  "balance  sheet." 

By  comparing  the  two  balance  sheets  it  will  be  seen  that 
the  "left-over"  or  "surplus"  is  greater  at  the  end  of  1919  by 
$327,000.  Clearly  this  must  be  explained  by  the  income  ac- 
count of  the  year  that  transpired  between  the  two  balance 
sheets.  It  is.  During  that  year  the  company  made  net  profits 
of  $1,774,000.  Of  this  net  profit  it  paid  out  $237,000  in 
dividends  on  the  preferred  stock  and  $1,210,000  on  the  com- 
mon stock.  Consequently  there  remained  $327,000  additional 
property  in  the  hands  of  the  company  at  the  end  of  the  year. 
This  explains  the  increase  of  $327,000  as  shown  by  the 
surpluses  in  the  two  balance  sheets. 

Surplus  and  Deficit. — From  this  brief  statement  of  actual 
accounts  it  will  be  seen  that  the  balance  sheet  is  merely  a  survey. 
On  one  side  of  a  sheet  of  paper  is  placed  all  the  property,  real 
and  personal,  material  and  intangible,  that  a  corporation  may 
own.  On  the  other  side  are  placed  the  amounts  it  owes.  And 
if,  as  is  very  improbable,  the  two  do  not  agree,  then  the  dif- 
ference is  inserted  as  a  kind  of  bookkeeping  adjustment.  If 
this  adjustment  has  to  be  inserted  on  the  debt  side,  it  Indicates 
that  the  debts  are  less  than  the  property  owned.  The  adjust- 
ment is  therefore  called  "surplus,"  or  left-over.  If  the 
adjustment  has  to  be  inserted  on  the  property  side  it  indicates 
that  the  debts  exceed  the  property.  It  is  therefore  called 
"deficit,"  or  "deficiency." 

Computation  of  Profit  or  Loss. — Any  changes  from  year 
to  year  in  the  surplus  or  in  the  deficit  arise  through  the  profits 
or  the  losses  in  the  business.  But  these  profits  or  losses  are 
not  easy  to  compute,  owing  to  the  numerous  and  intricate 
adjustments  that  must  ordinarily  be  made. 


XII  THE  IMPORTANCE  OF  ACCOUNTING  1 27 

On  tlie  surface  the  computation  of  profits  seems  simple 
and  explicit.  From  the  gross  revenue  or  receipts  of  the  busi- 
ness, the  direct  expenses — labor,  materials,  rent,  and  the  like — 
are  first  subtracted,  leaving  a  balance  which  is  the  gross  profit. 
This  is  easily  computed.  From  this,  the  net  profit  is  obtained 
by  a  series  of  adjustments.  It  is  these  adjustments  which 
cause  the  difficulties  of  both  accounting  theory  and  accounting- 
practice.  These  difficulties  arise  chiefly  in  transferring  in- 
tangible economic  values  into  figures.  In  spite  of  the  strictness 
and  apparent  rigidity  of  figures,  profit  or  loss  is  at  best  an 
estimate,  subject  to  all  the  inherent  errors  of  our  human  judg- 
ment. 

The  average  business  man  Is  uncritical.  Profit  to  him 
represents  the  difference  between  the  cost  of  his  goods  and 
the  amount  he  receives  for  them  after  he  has  made  adjust- 
ments for  what  he  had  on  hand  at  first  and  what  he  had  left. 
But  this  conception  of  profit  is  not  true  unless  the  phrase 
"cost  of  goods"  is  given  a  wider  significance  than  is  customary 
among  many  business  men.  The  goods  have  cost  not  only  what 
was  paid  for  them  but  also  what  was  lost  in  the  business 
through  handling  them. 

I.  Adjustments  of  Wasting  Assets. — It  is  necessary  to 
make  two  independent  sets  of  adjustments  in  order  to  reduce 
the  gross  profits  to  the  net  profits. 

The  first  series  of  adjustments  are  those  concerned  with 
the  wearing,  wasting,  deteriorating,  and  mere  aging  of  the 
physical  property  used  in  the  business.  The  buildings,  ma- 
chinery, tools,  and  all  the  fixed  assets  have  been  worn  and  have 
grown  less  valuable  during  the  time  in  which  the  goods  were 
being  manufactured  or  offered  for  sale;  many  accidents  and 
unforeseen  losses  have  occurred  which  must  be  included  among 
the  expenses  of  doing  business.  So  that  the  specific  cost  of  the 
goods  should  be  augmented  by  a  series  of  invisible  or  insensible 


128  CORPORATION  FINANCE  [  XI 

costs  which  can  only  be  estimated  roughly.  All  this  is  summar- 
ized in  the  idea  that  the  gross  profits  must  be  reduced  by  a 
series  of  adjustments  in  order  to  obtain  the  true  net  profit. 

2.  Adjustment  for  Losses  of  Reserves. — The  second  set  of 

adjustments  represents  the  losses  of  the  reserves  required  to 
meet  the  unforeseen  and  unpredictable  contingencies  that  arise 
in  every  business.  They  include  insurance,  accident  losses  and 
reserves,  special  liabilities  imposed  by  statutes,  and  reserves  for 
unprofitable  improvements  necessitated  by  the  public  demand. 
Although  individually  unpredictable  the  experience  of  every 
business  has  shown  that  these  expenses  and  losses  are  certain 
to  occur  in  one  way  or  another.  The  remainder  after  these  two 
sets  of  adjustments  have  been  made  represents  the  net  profit 
from  the  operation  of  the  business. 

Before  discussing  how  it  is  wisest  to  handle  this  net  profit, 
both  the  manager  and  the  investor  must  use  some  system  or 
rates  of  computing  it.  He  must  be  able  to  reduce  his  gross 
profit  to  net  profit  so  that  he  has  full  confidence  in  his  result. 
The  immediately  succeeding  chapters  discuss  how  this  should 
be  done. 


CHAPTER  XII 

REPAIRS,  DEPRECIATION,  AND  OBSOLESCENCE 

Definitions  and  the  Determination  of  Costs. — As  stated  at 
the  end  of  the  preceding  chapter,  the  first  set  of  adjustments 
that  must  be  made  to  the  gross  profit  from  the  operation  of  a 
business,  in  order  to  reach  the  net  profit,  covers  those  losses 
in  the  physical  property  which  are  due  to  wear,  breakage, 
and  the  deterioration  of  property  that  comes  merely  from 
age. 

Repairs  represent  the  costs  of  replacing  broken  and  worn 
equipment,  when  it  is  clear  that  the  replaced  part  has  a  rela- 
tively short  period  of  usefulness.  Its  cost  is  paid  for  directly 
out  of  the  current  earnings  and  it  is  presumed  that  the  basic 
capital  of  the  enterprise  is  merely  maintained,  not  increased, 
by  the  repair.  Depreciation  is  a  charge  against  earnings  which 
represents  the  insensible  loss  in  useful  value  of  all  equipment 
which  cannot  be  compensated  by  repairs — the  slow  crumbling 
of  a  foundation  or  the  insensible  oxidation  of  an  iron  casting. 
As  it  cannot  be  directly  compensated  for  by  any  specific  ex- 
penditure during  the  current  operation  of  the  business,  it  must 
be  ofifset  by  subtracting  a  certain  amount  from  the  gross  profits. 
This  deduction  is  thereafter  held  as  a  reserve  to  be  used  when 
the  equipment  is  finally  replaced,  that  is,  when  the  foundation 
has  entirely  crumbled  away  or  the  casting  entirely  gone. 
Obsolescence  is  a  charge  against  earnings  required  by  the  simple 
fact  that  tools,  machinery,  and  similar  material  equipment  pass 
out  of  date  before  their  apparent  usefulness  has  ceased,  that 
is,  before  their  full  life  has  run.  Like  depreciation,  it  must 
be  compensated  for  by  the  creation  of  a  reserve  which  may  be 
drawn  upon  when  it  becomes  wise  to  discard  a  still  serviceable 

9  129 


I30  CORPORATION  FINANCE  [XII 

machine  In  order  to  replace  it  by  one  of  more  modern  and 
efficient  construction. 

The  cost  of  repairs  can  be  exactly  stated.  It  is  known  with 
a  certainty,  provided  some  precise  method  of  charging  repairs 
is  adopted  and  the  books  of  record  are  correctly  kept.  Ex- 
perience can  give  a  fairly  accurate  basis  upon  which  to  judge 
of  the  length  of  life  of  tools  and  buildings,  so  that  the  deprecia- 
tion charge  is  more  exact  than  a  mere  guess ;  but  any  estimate 
must  necessarily  be  less  accurate  than  the  specific  payments  for 
repairs.  Obsolescence  can  be  predicted  much  less  precisely, 
because  a  new  invention  may  render  useless  machinery  recently 
installed.  Yet  by  using  a  large  number  of  machines  of  many 
kinds,  it  is  probable  that  the  so-called  "law  of  averages"  will 
enable  the  engineer  of  the  company  to  estimate  an  average 
obsolescence  constant  with  something  approaching  an  intel- 
ligent guess.  It  is  this  difference  in  accuracy  in  determining 
the  three  charges  that  makes  the  use  of  our  particular  classifica- 
tion expedient. 

Repairs. — The  repair  charges  are  definite  because  they  can 
be  measured  over  a  given  interval  of  time.  They  should  in- 
clude only  those  replacements  which  are  not  likely  to  be  of 
value  beyond  the  period  chosen  for  the  basis  of  computing  the 
earnings.  This  period  is  usually  a  year.  We  may  say,  there- 
fore, that  in  the  practical  procedure  of  current  accounting 
methods,  the  gross  profits  of  the  business  should  be  charged 
directly  and  specifically  with  all  replacements  and  repairs  which 
are  not  likely  to  have  an  effectiveness  beyond  a  single  year. 

No  reserve  for  repairs  should  be  created  and  no  reserve  ac- 
count is  ordinarily  kept.  If  such  a  reserve  appears  to  be  neces- 
sary in  a  certain  instance  it  would  be  clear  evidence  that  the 
replacement  which  the  reserve  was  intended  to  care  for  had 
a  significance  beyond  the  single  year  and  was  therefore  not 
a  repair  at  all,  but  belonged  to  one  of  the  other  charges,  due 


XII]  REPAIRS,  DEPRECIATION,  OBSOLESCENCE  131 

to  the  deterioration  and  replacement  of  more  permanent 
property.  Most  manufacturers,  however,  follow  the  practice 
of  classifying  as  repairs  all  small  charges.  There  is  no  doubt 
but  that  this  common  practice  of  considering  as  repairs  all 
replacements  of  low  cost,  irrespective  of  their  period  of  useful- 
ness, has  the  great  advantage  of  simplicity  and  ease  of  calcula- 
tion. Yet  it  has  no  logical  basis.  The  important  pragmatic 
distinction  between  a  repair  and  replacement  is  that  the  former 
is  a  charge  on  the  earnings  of  a  single  year  while  the  latter  is  a 
charge  against  the  earnings  of  several  years.  The  distinction 
is  therefore  one  of  time,  and  time  only.  It  has  nothing  what- 
ever to  do  with  the  cost  of  the  installation — whether  a  pane  of 
glass,  a  new  turbine  condenser  or  a  new  chimney.  However, 
convenience  is  a  sacred  canon  to  the  practicing  accountant,  and 
cost  will  probably  remain  as  the  basis  for  defining  repairs. 

Depreciation. — Depreciation  is  due  to  the  slow  deteriora- 
tion of  physical  property.  The  heavy  castings  of  a  great  tur- 
bine for  instance  slowly  corrode,  notwithstanding  the  frequency 
with  which  the  turbine  is  overhauled.  It  is  illogical  and  mislead- 
ing to  charge  the  cost  of  the  entire  new  machine  or  structure 
to  the  gross  profits  of  the  year  in  which  it  is  finally  cast  aside, 
for  its  decay  has  been  gradual  during  all  the  years  since  it  was 
installed.  Rather  should  each  year  bear  its  proportionate 
burden ;  and  in  order  to  charge  the  business  of  each  year  with 
this  proportionate  burden,  not  to  be  actually  expended  until 
years  afterward,  it  is  necessary  to  create  a  fund  out  of  current 
earnings  which  shall  accumulate  from  year  to  year  in  exact 
accordance  with  the  imperceptible  decay  of  the  machine. 

Needless  to  say  these  reserves  set  aside  each  year  must  be 
made  regularly  and  uninterruptedly,  and,  so  far  as  human  judg- 
ment permits,  in  exact  proportion  to  the  wearing  and  aging 
of  the  physical  property.  Under  no  condition  should  they  be 
made  to  correspond  to  the  relative  prosperity  of  the  business  or 


132  CORPORATION  FINANCE  I XII 

the  caprice  of  the  directors.  Under  no  condition  should  the 
depreciation  reserve  be  manipulated  for  speculative  purposes, 
or  made  so  markedly  irregular  as  to  suggest  that  it  was  mani- 
pulated according  to  income  or  in  order  to  avoid  federal  income 
taxes. 

An  example  of  the  poor  policy  of  that  kind  occurred  in  the 
history  of  the  American  Can  Company.  In  191 1  the  preferred 
stock  had  over  20  per  cent  accumulated  dividends  against  it. 
During  the  year  the  common  stock  was  quoted  between  8J^ 
and  12^.  The  fact  that  the  earnings  were  far  and  above  any 
previous  year  was  entirely  and  successfully  obscured  by  making 
a  secret  depreciation  charge  over  five  times  that  of  the  average 
of  the  preceding  five  years  and  over  four  times  that  of  the 
previous  year.  Consequently  the  net  earnings  after  deprecia- 
tion appeared  about  the  same  as  the  preceding  years,  and  gave 
no  intimation  of  increased  value  for  the  common  stock.  The 
"inner  ring"  of  directors  was  therefore  enabled  to  acquire 
large  amounts  of  both  common  and  preferred  stocks.  During 
the  year  191 2  the  large  earnings  of  the  American  Can  Company 
became  matters  of  public  knowledge  and  the  depreciation 
reserve  was  dropped  to  less  than  a  half  of  the  preceding  year. 
As  a  result  the  apparent  net  earnings  after  depreciation  ap- 
peared twice  as  great  as  before — a  rise  from  less  than  $3,000,- 
000  to  over  $6,500,000.  Consequently,  too,  the  common  stock 
rose  from  iij4  to  47^,  and  the  preferred  stock  from  90^  to 
126%.  As  a  result  of  this  manipulation  and  deception  the 
men  in  the  inner  circle  of  the  American  Can  Company's  affairs 
made  large  profits. 

At  any  time  the  unexpended  depreciation  reserve  ought  to 
represent  the  difference  in  physical  condition — expressed  in 
money — between  the  property  owned  by  the  corporation  and 
new  property  identical  with  it.  The  question  of  depreciation  is, 
it  should  be  pointed  out,  one  of  physical  property  and  not 
economic  value. 


XII]  REPAIRS,  DEPRECIATION,  OBSOLESCENCE  133 

Certain  kinds  of  property  may  be  maintained  at  their  full 
physical  condition  by  means  of  a  constant  and  uninterrupted 
series  of  repairs  and  replacements  without  any  reserves  for 
depreciation.  The  roadbed  of  a  large  railroad  system  alone  of 
all  the  property  likely  to  be  owned  by  a  corporation  meets  these 
conditions,  although  even  then  not  perfectly.  If  we  presume 
that  the  life  of  ties,  taking  a  specific  example,  is  seven  years, 
and  if  the  railroad  corporation  replaces  one-seventh  of  the  ties 
each  year,  that  part  of  the  roadbed  represented  by  ties  is  fully 
maintained.  And  if  the  life  of  a  steel  rail,  under  a  given  set  of 
conditions,  is  ten  years  and  the  railroad  replaces  one-tenth  of 
its  rails  each  year,  this  item,  too,  is  fully  maintained.  But 
repairs  to  the  ballast  and  gravel  bed  itself  are  not  so  easily 
adjusted  by  this  method,  and  all  the  other  expenses  of  mainte- 
nance of  a  railroad's  way  are  kept  up  with  difficulty  except 
through  depreciation  reserves.  To  the  rigid  insistence  of  the 
pioneers  of  railroad  accounting  that  maintenance  charges  be 
liberal  and  that  there  must  be  a  real  addition  to  property  before 
an  expenditure  shall  be  taken  out  of  the  charges  for  mainte- 
nance and  considered  a  real  improvement,  is  due  the  relatively 
low  capitalization  of  our  American  railroads. 

Obsolescence. — Maintenance  of  property  does  not  in  the 
least  insure  the  continued  earning  capacity  or  economic  value 
of  the  property.  This  is  particularly  true  in  manufacturing 
businesses  of  all  kinds  where  competition  is  so  keen  that  only  by 
taking  advantage  of  the  most  efficient  machinery  can  the  manu- 
facturer hope  to  reduce  his  costs  of  production  to  such  a  level 
that  he  can  do  business  at  a  profit.  One  of  the  commonest 
causes  of  failure  among  manufacturers  is  the  reluctance  to 
"scrap"  machinery,  still  good  of  its  kind,  which  has  been  super- 
seded by  better  and  faster  models.  A  manufacturer  may  have 
set  aside  sufficient  reserves  to  replace  his  old  machinery  when  it 
is  entirely  worn  out,  but  these  reserves  are  inadequate  to  meet 


134  CORPORATION  FINANCE  [XII 

the  cost  of  new  machinery  when  there  is  still  some  life  left  in 
the  old.  The  appearance  of  a  new  competitor  with  thoroughly 
modern  equipment  makes  certain  the  failure  of  the  long- 
established  manufacturer. 

Property  may  become  out  of  date  from  a  variety  of  causes. 
The  commonest  is  the  invention  of  new  machinery  that  can 
do  the  work  better  or  cheaper.  But  there  are  other  causes  not 
thought  of  at  first.  A  sudden  change  in  style  may  make  thou- 
sands of  dollars'  worth  of  the  lasts  of  a  shoemaker  or  the 
patterns  of  a  dress  goods  manufacturer  utterly  worthless.  A 
sudden  change  in  the  public's  fancy  may  make  useless  great 
amounts  of  machinery  devoted  to  a  special  purpose.  A  notable 
instance  of  this  is  the  case  of  the  old  American  Bicycle  Com- 
pany, the  machinery  of  which  became  practically  worthless  as 
the  public's  plaything  changed  from  the  bicycle  to  the  auto- 
mobile. Even  a  change  in  relative  labor  costs  may  render  large 
quantities  of  machinery  obsolete.  When  the  New  England 
Cotton  Yarn  Company  was  organized,  its  spinning  machinery 
consisted  almost  entirely  of  English  mules,  requiring  skilled 
labor  for  their  operation.  Many  of  the  mule  spinners  were 
Englishmen.  The  supply  of  this  highly  skilled  labor  decreased, 
whereas  the  demand  for  it  increased.  As  a  consequence,  within 
a  couple  of  years  the  wages  for  mule  spinners  had  risen  so 
high,  comparatively,  that  it  was  cheaper  to  spin  coarse  and 
medium  yarns  on  ring  frames  the  operatives  of  which  were 
paid  the  wages  of  unskilled  labor.  To  meet  this  change  of 
labor  conditions  the  company  was  compelled,  ultimately,  to 
throw  away  thousands  of  dollars'  worth  of  mules  having  many 
years  of  usefulness  remaining  to  them,  and  replace  them  by 
ring  frames.  Changes  in  social  condition  may  make  it  ex- 
pedient to  provide  improved  or  altogether  different  surround- 
ings for  factories;  social  conditions  may  also  require  the  sub- 
stitution of  improved  public  utilities ;  as  a  result,  the  older, 
more  obsolete  facilities  cease  to  have  any  value  whatsoever. 


XII]  REPAIRS,  DEPRECIATION,  OBSOLESCENCE  135 

The  ferry  boats  plying  between  Manhattan  and  Brooklyn  were 
once  a  public  necessity  and  of  great  value.  The  bridges 
superseded  the  ferries  and  the  boats  had  little  more  than 
scrap  value. 

It  is  easy  to  perceive  the  theoretical  necessity  for  an  ob- 
solescence reserve,  but  it  is  exceedingly  difificult  to  determine, 
in  practice,  the  appropriate  annual  amounts  that  must  be  set 
aside  out  of  gross  earnings.  No  one  knows  when  a  machine 
will  become  obsolete,  nor  the  cost  of  the  improved  model 
which  supersedes  it.  It  is,  it  would  seem,  a  guess  based  on  a 
guess.  And  this  is  strictly  true  in  a  concrete  case;  but  it  is 
not  true  in  the  large  average  of  cases.  One  must  admit  that 
it  is  obviously  impossible  to  set  aside  a  regular  annual  allow- 
ance, so  that  when  at  an  unknown  time  in  the  future  a  machine 
of  uncertain  cost  must  be  paid  for,  the  fund  will  be  just 
suf^cient  to  meet  it.  But  it  is  possible  to  set  aside  an  annual 
allowance  which  will  gradually  create  a  fund  from  which  may 
be  drawn  the  extraordinary  costs  of  replacing  usable  ma- 
chinery by  new  and  improved  forms.  The  amount  of  this 
annual  allowance  must  depend  on  the  nature  of  the  business. 
Some  parts  of  the  plant  will  surely  become  obsolete  before 
they  are  worn  out;  some  parts  will  not.  In  a  central  station 
electric  light  system,  it  is  almost  certain  that  the  generating 
units  will  be  superseded  by  more  efficient  models  before  they 
are  worn  out ;  it  is  equally  certain  that  the  copper  wire  will  be 
quite  as  valuable  for  the  purpose  of  the  electric  light  company 
many  years  hence  as  it  was  when  first  installed.  It  may  never 
become  obsolete.  Between  these  two  extremes  there  is  much 
of  the  equipment  that  will  probably,  but  not  certainly,  be 
superseded  before  it  is  worn  out,  much  that  probably  will  be 
worn  out  before  it  becomes  obsolete.  The  engineer  is  fully 
conscious  of  these  probabilities.  He  may  conclude,  for  illus- 
tration, that  a  third  of  the  original  cost  of  a  normal  central 
station  electric  system — representing  such  parts  as  wire  and 


136  CORPORATION  FINANCE  [XII 

insulators — will  not  be  superseded  by  improved  forms.  This 
part  of  the  plant  requires  no  obsolescence  reserve.  He  may 
conclude  that  another  third  may  be  superseded,  but  that  the 
extent  cannot  be  predicted.  Some  slight  obsolescence  reserve  is 
required  for  this  third,  in  addition  to  the  regular  depreciation 
reserve.  The  property  representing  the  remaining  third  will 
almost  surely  be  superseded  before  it  is  worn  out,  but  the 
time  will  be  uncertain.  A  very  substantial  reserve  will  be 
required  for  this  portion  of  the  corporation's  property. 

The  Important  Principle  of  All  Reserves. — There  are  no 
undisputable  canons  of  accountancy  that  require  exactly  that 
the  three  charges  of  repairs,  depreciation,  and  obsolescence  be 
made  against  gross  earnings  in  order  to  reach  the  net  earn- 
ings of  the  business.  The  fundamental  principle  is  that 
earnings  cannot  be  considered  as  net  earnings,  as  real  earnings, 
until  there  is  assurance  that  the  economic  value  of  the  prop- 
erty of  the  business,  as  evidenced  by  power  to  earn,  has  not 
declined  during  the  period  in  which  the  earnings  are  being 
made.  The  capital  fund  employed  in  the  business  must  remain 
intact.  Clearness,  in  the  sense  of  being  susceptible  to  but 
one  interpretation,  and  truth,  in  the  sense  of  expressing  a 
money  value  for  an  economic  value  that  is  exact  within  a 
predictable  limit  of  error — those  qualifications  are  the  ideals 
for  the  methods  of  accountancy. 

Objectionable  Accounting  Practices. — Certain  objection- 
able practices  have  crept  into  the  treatment  of  depreciation 
charges  that  call  for  condemnation  whatever  theory  of 
accountancy  one  accepts.  Foremost,  because  the  least  logical, 
is  the  practice  of  assuming  that  the  payments  to  the  sinking 
fund  of  a  corporation's  bonds  will  offset  the  depreciation 
and  obsolescence  reserves.  The  sinking  fund  is  maintained 
to  safeguard  the  market  value  of  the  bonds  or  facilitate  re- 


XIII  REPAIRS,  DEPRECIATION,  OBSOLESCENCE  137 

funding  them.  There  is  no  conceivable  connection  between  the 
amount  demanded  by  the  investment  banker  as  an  adequate 
sinking  fund  allowance  and  the  rate  at  which  the  property 
of  the  corporation  grows  old  and  useless.  In  practice  the 
sinking  fund  is  a  certain  percentage  of  the  bonds.  Made 
universal,  it  would  imply  that  the  larger  a  corporation's  debt 
the  more  rapidly  its  property  would  decay  and  become  out  of 
date.  This  is  nonsense.  Furthermore,  as  the  sinking  fund 
increases,  the  debt  gradually  decreases  in  amount  and  with 
it  the  sum  that  must  be  paid  into  the  fund  each  year.  This 
implies  that  the  wasting  and  aging  of  a  corporation's  property 
grow  less  as  the  corporation  grows  older — again  nonsense. 

Another  objectionable  practice  in  connection  with  deprecia- 
tion is  that  of  allowing  new  construction  to  offset  the  various 
charges  which  we  have  called  here  "depreciation"  and  "obso- 
lescence." The  sinking  fund  payments  are  regular  and  cer- 
tain, and  as  such  correspond  to  the  regularity  and  certainty 
of  the  decay  of  physical  property.  But  new  construction 
has  not  even  this  advantage  of  being  regular  and  certain. 
During  periods  of  pronounced  business  activity  there  will 
be  large  amounts  of  construction,  during  periods  of  depres- 
sion, little  or  none.  From  the  corporation's  point  of  view,  it  is 
very  convenient  to  allow  the  charges  to  depreciation  only  during 
years  of  pronounced  activity  and  large  profit,  but  such  a  method 
gives  a  false  picture  of  the  business  and  is  therefore  wrong. 

A  third  bad  practice,  tolerated  quite  extensively  by  public 
service  accountants,  is  based  on  the  theory  that  depreciation 
can  be  cared  for  by  setting  aside  a  certain  proportion  of  the 
gross  earnings  of  the  business.  Clearly  the  aging  and  wast- 
ing of  a  large  proportion  of  the  equipment  of  the  business 
bears  little  relation  to  the  amount  of  business  done,  and  less 
to  the  amount  of  gross  profits.  Carried  to  the  extreme  it 
would  mean  that  when  the  corporation  earned  no  gross  profits 
its  property  would  neither  age  nor  wear  out. 


CHAPTER  XIII 

PAYMENTS   ON   ACCOUNT   OF   BORROWED 
CAPITAL 

Interest  Charges  Against  Net  Profits. — According  to  the 
notation  used  in  the  foregoing  chapter,  gross  profits  represent 
the  mere  difference  between  the  total  receipts  for  the  goods  sold 
and  the  total  expenditures  involved  in  their  production  and 
sale.  Net  profits  represent  the  gross  profits  of  the  business 
after  there  have  been  made  deductions  for  repairs  and  such 
deterioration  of  equipment  and  intangible  property  as  is  due 
to  use  and  age.  So  described,  net  profit  is  the  surplus  left 
after  the  direct  outlays  have  been  paid  and  the  capital  brought 
up  to  the  same  point  of  value  as  it  was  at  the  beginning.  It 
does  not  take  into  consideration  the  amount  of  capital  in- 
volved; nor  does  it  distinguish  between  the  capital  owned  by 
the  proprietors  of  the  business  and  that  borrowed  from 
outside  sources. 

To  reduce  net  profits  to  an  amount  which  the  directors 
may  use  in  estimating  surplus  earnings  available  for  special 
and  general  reserves  and  for  distribution  among  the  stock- 
holders as  dividends,  a  further  adjustment  is  required,  which 
involves  the  apportionment  of  the  net  profits  between  the 
actual  proprietors  of  the  business  and  those  who  have  lent 
capital.  The  business  must  earn  enough  net  profits  to  pay 
its  interest  charges  before  there  shall  be  any  remainder 
either  to  put  back  into  the  business  or  to  distribute  to  the 
stockholders. 

Classification     of     Payments     for     Borrowed     Capital. — 
Payments   for  borrowed  capital  usually  enter  into  the  busi- 
es 


XIII]  PAYMENTS  ON  BORROWED  CAPITAL  139 

ness  in  five  different  ways.  There  are  discounts  given  and 
taken  on  merchandise  sold  and  bought,  for  the  payment  of 
cash  before  the  bill  is  actually  due.  There  are  interest  charges 
paid  to  the  banks  in  the  form  either  of  interest  or  of  bank 
discount.  There  are  interest  charges  paid  to  the  public  in 
the  form  of  bond  and  note  interest.  There  are  direct  charges 
against  profits  arising  from  the  use  of  other  people's  property, 
tangible  and  intangible,  which  take  the  form  of  rentals  and 
royalties.  Lastly  there  are  interest  charges  indirectly  paid 
by  selling  bonds  at  less  than  their  par  value,  a  procedure 
which  requires  throughout  the  life  of  the  bond  an  annual 
charge  to  bond  discount. 

Cash  Discounts. — If  the  cash  discounts  given  and  taken 
exactly  balance,  it  will  indicate  that  no  adjustments  to  net 
profits  are  necessary,  because  the  corporation  is  lending  its 
capital  to  its  customers  or  borrowing  capital  from  its  creditors. 
In  case  cash  discounts  are  taken  by  the  corporation  in  an 
amount  in  excess  of  what  are  taken  by  its  customers,  there 
must  be  an  adjustment  to  show  that  the  corporation  earned 
something  by  financing  the  merchandise  stocks  of  its  cus- 
tomers. This  amount  should  be  shown  clearly  as  an  addition 
to  net  profits  and  not  as  a  part  of  net  profits,  because  the 
amount  represents  a  kind  of  banking  profit,  inherently  differ- 
ent in  character  from  the  profit  obtained  through  the  ordinary 
conduct  of  the  business.  Similarly,  if  the  discounts  taken 
are  less  than  those  given,  the  difference  should  be  shown  as 
a  deduction  from  net  profits  to  indicate  that  some  of  the 
apparent  net  profit  was  made  by  using  the  capital  of  the  cor- 
poration's creditors. 

Bank  Discount. — Bank  discount  as  interest  paid  for  the 
carrying  of  merchandise  loans  is  more  clearly  defined.  Like 
cash  discount,  it  should  represent  an  adjustment  to  the  net 


I40  CORPORATION  FINANCE  [  XIII 

profits.  Ordinarily  it  is  a  deduction,  as  the  company  has, 
presumably,  borrowed  from  its  banks.  But  it  sometimes 
happens  that  the  corporation  has  been  amply  provided  by  its 
stockholders  with  capital,  so  that  it  may  receive  interest  from 
its  bank  deposits.  Clearly  this  would  be  an  addition  to  net 
profits,  and  should  be  shown  as  a  banking  profit  and  not  as  a 
profit  from  the  ordinary  conduct  of  the  business. 

Interest  on  Funded  Debt. — It  is  equally  clear  that  interest 
paid  on  the  public  debt  of  the  company  should  be  a  direct 
charge  against  net  profits  and  not  a  mere  incidental  deduction 
from  the  gross  profits,  as  it  has  sometimes  been  regarded. 
If  the  corporation,  like  the  American  Sugar  Refining  Company, 
or  the  express  companies,  before  the  Great  War,  had  loans  to 
other  companies  the  interest  on  these  loans  is  an  addition  to 
the  net  profits  of  the  business.  This  is  true  even  when  the 
interest  is  received  from  another  corporation  engaged  in  a 
similar  line  of  business,  as  dividends  received  by  one  rail- 
road on  the  railroad  stocks  held  in  its  treasury.  The  dis- 
tinguishing test,  which  should  indicate  whether  or  not  the 
dividends  or  profits  of  a  subsidiary  or  allied  company  are  to 
be  regarded  as  parts  of  the  net  profits  of  the  parent's  business 
or  additions  to  the  net  profit,  is  the  amount  of  control  exercised 
over  the  subsidiary  and  the  closeness  with  which  the  two 
businesses  are  connected.  It  would  be  wrong  for  the  United 
States  Steel  Corporation  to  pretend  that  its  ore-carrying  and 
smelting  companies  are  other  than  mere  subsidiaries  of  its 
main  organization,  or  that  their  profits  are  additions  to  its 
own  profits.  On  the  contrary,  it  would  be  equally  wrong 
for  the  American  Express  Company,  the  second  largest  stock- 
holder in  the  New  York,  New  Haven  and  Hartford  Railroad, 
to  pretend  that  the  railroad's  profits,  if  such  there  are,  should 
be  regarded  as  a  part  of  the  net  profits  of  the  express  business. 

This  distinction  is  strictly  true  whether  the  subsidiary  is 


XIII]  PAYMENTS  ON  BORROWED  CAPITAL  14I 

merely  another  corporation  of  the  same  kind  doing  the  same 
business,  or  a  corporation  of  a  different  kind  whose  business 
is  secondary  to  and  contributory  to  that  of  the  main  corpora- 
tion. In  the  former  case  the  separation  may  be  for  merely 
legal  reasons.  Thus  the  laws  of  Texas  require  a  railroad 
operating  in  that  state  to  be  incorporated  there.  It  is  there- 
fore strictly  correct  to  consolidate  the  accounts  of  the  main 
road  and  the  subsidiary,  since  the  two  constitute,  for  all  pur- 
poses of  financial  analysis,  one  and  the  same  corporation.  In 
the  latter  case,  when  the  subsidiary  is  only  a  subordinate  of 
the  main  company,  it  keeps  a  separate  set  of  books,  merely 
because  the  businesses  are  dififerent.  During  the  summer  and 
autumn  of  191 7  many  public  utility  companies,  especially  in 
the  Middle  West  (notably  the  Detroit  Edison  Company) 
purchased  coal  mines  in  order  to  insure  themselves  against 
a  threatened  coal  famine.  Thereafter  the  apparent  earnings 
of  the  public  utility  could  be  manipulated  at  will  by  shifting 
the  prices  and  conditions  of  purchase  under  which  the  mining 
subsidiary  billed  its  coal  to  the  parent  public  utility.  Obviously 
the  only  fair  way  would  be  to  consolidate  the  profit  and  loss 
accounts  of  the  two.  Perhaps  the  mine,  in  addition  to  supply- 
ing the  parent  with  coal,  also  sold  coal  on  the  open  market. 
In  this  case  an  entirely  separate  and  distinct  profit  and  loss 
account  must  be  kept  for  the  mine  (provided  the  price  charged 
to  the  parent  was  the  same  as  that  charged  to  the  outside 
customer),  because  then  the  mine  was  standing  on  its  own 
feet,  as  an  independent  concern,  and  its  success  or  failure 
should  be  evidenced  by  its  own  accounts. 

The  most  exhaustive  and  elaborate  system  of  accounts 
that  attempts  to  separate  the  sources  of  income  in  accordance 
with  this  principle  of  the  closeness  of  control  and  interde- 
pendence of  corporations  is  that  of  the  Union  Pacific,  about 
1909.  The  Union  Pacific  Railroad  derived  its  profit  from  six 
types  of  companies   (besides  its  own  railroad  running  from 


142  CORPORATION  FINANCE  [  XIII 

Omaha  to  Ogden)   whose  financial  and  operating  conditions 
were  in  various  degrees  of  closeness  to  the  parent  company : 

1.  Accounts  consolidated,  so  that  there  is  a  single  profit  and  loss 

account;  assets  and  liabilities  consolidated  so   that  there   is  a 
single  consolidated  balance  sheet. 

(a)  Fundamental    parent:    Union     Pacific    Railroad.     Council 

Bluffs,  Iowa  (Omaha),  to  Ogden,  i,ioi  miles,  together 
with  the  branches  operated  as  a  single  operating  unit, 
3,390  miles.  This  is  the  fundamental  operating  and 
financial  nucleus. 

(b)  Auxiliary   companies: 

(i)  Oregon  Short  Line  Railroad.  Ogden  to  Hunting- 
ton, Oregon,  with  branches,  1,178  miles. 

(2)  Oregon  Railroad  and  Navigation  Company.  Hunt- 
ington, Oregon,  to  Portland,  with  branches,  1,143 
miles.  Two  large  railroad  systems  the  stock  of 
which  is  entirely  (except  a  few  shares)  owned  by 
the  Union  Pacific  Railroad.  Operated,  from  the 
point  of  view  of  the  company,  separately,  but  the 
operations  consolidated  with  those  of  the  parent 
before  presenting  to  public. 

(c)  Proprietary    companies:      Utah     and     Northern     Railway, 

Columbia  River  and  Oregon  Central,  etc.  In  all,  ly 
small  corporate  entities,  parts  of  the  Union  Pacific  Rail- 
road or  its  two  auxiliaries,  the  corporate  independence 
of  which   is  retained   for  legal   or  other   reasons. 

2.  Accounts  independent.     Income  comes  into  the  treasury  of  the 

Union  Pacific  Railroad  as  interest  on  invested  capital : 

(a)  Investments   entirely   controlled   and   owned:   Oregon   and 

Washington  Railroad,  Central  Idaho  Railway,  Union 
Pacific  Coal,  and  a  variety  of  small  corporations. 

(b)  Investments  entirely  controlled,  but  only  partially  owned: 

St.  Joseph  and  Grand  Island  Railroad,  Southern  Pacific 
Company,   and  other   smaller  corporations. 

(c)  Investments  partly  controlled  and  partly  owned:   Chicago 

and  Alton  Railway,  Kansas  City  Terminal,  Illinois 
Central. 

(d)  Investments  over  which  the  parent  has  little  control  and 

owns  only  a  small  part  of  the  outstanding  securities — 


XIII]  PAYMENTS  ON  BORROWED  CAPITAL  I43 

investments,  strictly  speaking,  although  in  many  cases 
the  parent  profits  by  close  trafific  agreements :  Atchison, 
Topeka  and  Santa  Fe ;  Baltimore  and  Ohio ;  Chicago  and 
Northwestern ;  Chicago,  Milwaukee  and  St.  Paul ;  New 
York  Central  and  Hudson  River  Railroad. 

Rentals  and  Royalties. — It  is  clear  that  in  the  vast  majority 
of  cases  rentals  for  the  use  of  tangible  property  are  in  all  re- 
spects identical  with  interest  payments,  except  in  the  control 
or  administration  of  the  hired  property.  Similarly,  with 
certain  forms  of  a  railroad's  rolling  stock,  the  question  whether 
the  equipment  is  bought  outright  or  merely  hired  resolves 
itself  into  a  question  of  the  cost  of  hiring  money  or  pay- 
ing daily  car  rentals — a  problem  primarily  of  the  money 
market. 

When  the  property  leased  is  of  large  value  and  its  earning 
power  subject  to  abrupt  and  unpredictable  fluctuation,  the 
rentals  are  sometimes  arranged  on  the  basis  of  the  indepen- 
dent earning  power  of  the  leased  property.  Especially  is  this 
practice  common  if,  as  in  the  case  of  railroads,  a  separate  and 
independent  record  may  be  kept  of  the  amount  of  business 
which  the  leased  line  brings  the  main  road,  or  of  the  earnings 
arising  from  the  operation  of  the  leased  line  alone. 

Rentals  paid  for  the  use  of  property  rights  are  in  some 
respects  different  from  those  paid  for  the  use  of  tangible 
property.  These  rental  costs  will  vary  greatly  according  to 
the  nature  of  the  business.  In  manufacturing  businesses 
sometimes  royalties  cover  water  rights,  power  sites,  or  ease- 
ments, but  more  frequently  they  represent  royalties  for  the 
use  of  patents.  Frequently  a  company  is  organized  whose 
only  asset  is  the  ownership  of  a  patent  and  its  only  receipts 
the  royalties  paid  by  one  or  more  companies  manufacturing 
under  the  license  of  this  patent.  In  the  case  of  public  utility 
companies  these  payments  are  for  the  use  of  other  companies' 
rights  of  way  and  easements,  for  rights  under  "break  down" 


144  CORPORATION  FINANCE  [XIII 

contracts,  and,  in  some  cases,  rights  under  previously  granted 
franchises. 

A  rental  representing  both  payment  for  the  use  of  property 
and  property  rights  together  is  that  exacted  for  licensed 
machinery.  The  actual  cost  of  manufacturing  a  Goodyear 
welting  machine  is  probably  not  over  $i,ooo.  The  United 
Shoe  Machinery  Company  charges  6  cents  a  pair  "royalty" 
or  rental  for  the  use  of  that  machine,  so  that  in  the  extreme 
case  of  an  operator  turning  out  300  pairs  a  day  the  rentals 
on  the  single  machine  would  amount  to  $18  a  day,  or  over 
$5,000  a  year.  Obviously  only  a  small  proportion  of  this 
is  represented  by  interest  on  physical  capital.  Here  the 
rental  is  determined  not  by  the  cost  of  producing  the  machinery 
itself,  but  by  the  economy  to  the  users.  And  conversely,  if 
the  corporation  receives  an  amount  for  the  use  of  its  patents 
or  other  exclusive  privileges,  such  receipts  should  enter  the 
accounts  as  additional  receipts,  supplemental  to  the  regular 
income  and  expenditure  of  the  business. 

From  what  has  been  said  it  seems  clear  that  the  various 
costs  incident  to  the  use  of  the  capital  of  others  in  a  business 
should  be  considered  together  as  deductions  from  net  profits 
and  should  not  be  treated  as  expenses  of  the  business.  From 
every  point  of  view,  except  the  method  of  payment,  cash  dis- 
counts, bank  interest,  interest  on  funded  debt,  and  rentals, 
are  the  same.  All  should,  therefore,  be  regarded  as  the  cost 
of  using  others'  capital,  not  the  cost  of  operating  the  business. 
Similarly,  from  the  other  side,  receipts  from  cash  discounts, 
interest  allowed  by  the  bank,  and  dividends  and  interest  re- 
ceived from  securities,  should  be  regarded  as  an  addition  to, 
and  not  as  a  part  of,  the  net  profits  of  the  business. 

The  Amortization  of  Bond  Discount. — The  cost  of  capital 
is  frequently  paid  in  directly  through  the  sale  of  securities 
at  a  discount.     A  corporation  whose  credit  is  on  a   5   per 


XIII]  PAYMENTS  ON  BORROWED  CAPITAL  145 

cent  basis  may,  for  illustration,  sell  20-year  5  per  cent  bonds 
at  par.  The  same  bonds  may  be  sold  at  about  114  if  they  are 
made  to  bear  6  per  cent,  or  at  88  if  4  per  cent.  If  this  is 
borne  in  mind  it  is  clear  that  when  a  corporation  elects  to  sell 
its  bonds  for  less  than  par  it  has  secured  the  right  through- 
out the  life  of  the  bond  to  pay  a  lower  coupon  rate  of  interest 
than  the  corporation's  credit  would  warrant  at  the  time  the 
bonds  were  issued.  For  this  reason  the  discount  or  deduc- 
tion from  par  at  which  the  bonds  are  sold  should  run  through 
all  the  years  that  the  bonds  are  outstanding.  It  should,  in 
efifect,  be  regarded  as  a  kind  of  supplementary  burden  which 
the  corporation  shall  be  compelled  to  carry  throughout  the 
life  of  the  bond  to  balance  a  lower  coupon  rate  of  interest 
than  was  warranted  by  the  credit  of  the  corporation  when  the 
bonds  were  originally  sold.  So  regarded,  it  is  a  deduction 
from  the  net  earnings,  indistinguishable  in  theory  from  the 
regular  coupon  interest  on  the  bonds.  In  practice,  however, 
it  is  not  paid  to  the  holders  of  the  bonds,  but  is  paid  into  a 
reserve  fund  which  will  extinguish  the  bond  discount  at  the 
time  the  bonds  are  due.  Conversely,  in  those  rare  cases 
when  bonds  are  sold  at  a  premium,  this  premium  should  be 
employed  to  reduce,  each  year,  the  interest  paid  on  the  bonds 
by  a  proportionate  annual  instalment.  When  the  bonds  fall 
due  the  discount  or  the  premium,  according  as  the  bonds  were 
sold  for  less  or  more  than  par,  will  have  been  entirely  extin- 
guished through  the  annual  adjustments  to  the  regular  coupon 
disbursements. 

Expenses  Involved  in  Sinking  Funds. — Again  any  expenses 
involved  in  a  sinking  fund  must  be  charged  off  before  the 
account  is  entirely  free  of  all  charges  for  the  use  of  borrowed 
capital.  This  introduces  many  complexities  in  the  treatment 
of  sinking  funds,  and  the  actual  amount  of  net  earnings  is 
sometimes  obscured  by  the  manner  in  which  they  are  treated. 


146  CORPORATION  FINANCE  I XIII 

The  increase  in  the  market  price  of  corporation  bonds 
by  reason  of  the  presence  of  a  sinking  fund  is  one  of  the  most 
interesting  aspects  of  corporation  finance,  because  its  causes 
are  essentially  psychological.  They  are  remnants  of  a  point 
of  view  which  regarded  corporation  finance  as  grounded  on 
the  same  principles  as  private  finance — remnants  of  the 
original  sharp  divergence  between  the  position  of  owner  and 
that  of  creditor.  The  stockholder  recognizes  the  permanence 
of  his  investment,  but  the  bondholder  clings  to  the  fiction  that 
his  security  must  be  redeemed  in  money  by  the  corporation 
at  a  certain  definite  time.  He  assumes  that  the  bonded  lien 
on  the  corporation's  assets  is  but  temporary  and  that  the 
stockholders  look  forward  to  the  time  when  the  corporation 
shall  be  free  from  debt.  The  corporation  managers  in  plac- 
ing the  bond  issues  must  defer  to  this  prejudice  on  the  part 
of  investors  because  by  so  doing  they  can  borrow  more  cheaply. 

Occurrence  of  Sinking  Funds. — Until  1893  the  sinking 
fund  provision  was  common  among  railroad  bond  issues. 
It  gave  considerable  trouble,  however,  as  a  trustee  of  a  bond 
issue  would  not  force  the  payment  of  the  instalments  if  such 
a  course  was  likely  to  result  in  a  receivership.  In  that  event 
the  bonds  which  he  was  seeking  to  protect  would  be  injured 
to  a  vastly  greater  degree,  as  experience  had  shown  that  the 
publicity  of  a  railroad's  financial  disaster  hurts  the  value  of 
every  one  of  its  bond  issues,  even  the  most  secure.  The 
trustee,  therefore,  merely  brought  pressure  to  bear  on  the 
railroad  corporation  to  meet  the  sinking  fund  obligation,  but 
if  the  management  remained  obdurate  nothing  was  accom- 
plished. So  that  in  practice,  at  the  critical  moment  when 
the  sinking  fund  was  intended  to  be  of  most  use  in  protecting 
the  bonds,  it  proved  to  be  completely  inefifective.  As  the 
bonded  debt  was  reduced,  through  successive  reorganiza- 
tions, to  an  amount  well  within  the  replacement  cost,  the  in- 


Xni]  PAYMENTS  ON  BORROWED  CAPITAL  I47 

vestors  recognized  that  the  courts  would  protect  the  railroad, 
under  all  ordinary  circumstances,  in  the  payment  of  the 
underlying  bonds.  Beginning  about  1894  these  bonds  were 
therefore  made  of  late  maturity,  and  were  not  provided  with 
sinking  fund  provisions.  They  were,  in  effect,  irredeemable 
debts.  During  each  successive  year,  through  the  reinvest- 
ment of  earnings  and  the  proceeds  of  the  sales  of  overlying 
securities  in  the  physical  property  of  the  roads,  the  security  of 
these  long-term  bonds  has  been  strengthened  much  more  than 
any  sinking  fund  could  have  done. 

Since  1893  most  of  the  old  underlying  sinking  fund  rail- 
road bonds  have  either  been  paid  off  or  else  refunded  into 
the  large  permanent  general  mortgage  issues.  But  the  prac- 
tice of  issuing  bonds  with  a  sinking  fund  requirement  is  much 
commoner  outside  railroad  issues.  Investors  have  not  been 
ready  to  concede  to  other  forms  of  private  enterprise  the 
public  character  of  railroads,  so  they  have  required  the  pres- 
ence of  the  sinking  fund  provision  to  make  more  certain  the 
refunding  or  the  redemption  of  the  bonds  at  maturity.  This 
is  especially  true  in  case  of  industrials,  presumably  because 
of  the  instability  of  the  earning  capacity  of  the  property 
behind  the  bonds.  Similarly,  practically  every  one  of  the 
few  bonds  issued  by  mining  corporations  is  protected  by  a 
sinking  fund  requiring  that  the  bonds  be  paid  off  as  rapidly  as 
the  coal  or  ore  is  dug  from  the  earth. 

Treatment  and  Investment  of  Sinking  Funds. — The  funda- 
mental purpose  of  the  sinking  fund  is  to  reduce  the  ratio 
between  the  amount  of  the  debt  and  the  value  of  property  by 
which  it  is  secured.  The  margin  above  the  bonds,  the  equity,  is 
increased.  Different  provisions  apply  to  the  operation  of 
different  sinking  funds,  but  this  end  is  the  primary  one  in 
all  cases.  The  variations  concern  either  the  rates  of  payment 
into  the  sinking   fund  reserve  or  the  manner  in  which  the 


148  CORPORATION  FINANCE  [XIII 

reserve  shall  be  invested.  These  variations,  some  of  which 
are  of  considerable  significance,  are  almost  innumerable. 

The  usual  requirement  for  the  investment  of  sinking  fund 
reserves  is  that  the  bonds  of  the  same  issue  be  bought  on 
the  open  market  and  canceled.  Sometimes  the  bonds  are  not 
canceled  but  are  held  by  the  trustees  and  interest  collected 
upon  them,  the  proceeds  of  which  are  used  for  additional 
bond  purchases.  It  is  usually  provided  that  the  bonds  to  be 
acquired  for  the  sinking  fund  may  be  purchased  in  the  open 
market  at  the  price  specified  in  the  bond  as  the  call  price,  and 
further  that  if  they  are  not  procurable  at  the  fixed  price  or 
lower,  they  may  be  called  by  lot.  It  is  important  that  the 
corporation  or  trustee  be  empowered  to  call  the  bonds  or 
otherwise  the  holders  may  exact  a  high  price,  especially  if 
the  bonds  are  closely  held.  And  further  it  is  important  that 
the  bonds  be  callable  by  lot,  for  otherwise  certain  holders 
may  be  discriminated  against  if  the  call  price  becomes  less 
than  the  market  price. 

If  a  fund,  instead,  is  created  to  be  used  finally  in  the 
purchase  of  the  bonds  when  they  fall  due,  the  same  care 
should  be  used  in  keeping  it  intact  as  in  the  investment  of  an 
insurance  fund.  When  it  is  not  invested  in  other  bonds  and 
securities  the  corporation  may  sometimes  use  it  to  construct 
new  property,  or  for  improvements  covered  by  the  original 
mortgage.  By  increasing  the  value  of  the  property  beyond 
its  normal  depreciation  the  security  of  the  outstanding  bonds 
is  correspondingly  increased.  Moreover,  it  is  often  possible 
for  the  management  to  make  improvements  in  the  mortgaged 
property  so  that  the  earning  capacity  of  the  corporation  can 
be  kept  abreast  of  the  advances  in  technical  construction.  In 
this  way  the  equity  of  tangible  property  itself  is  increased 
and  the  equity  of  earning  capacity  as  well.  This  use  of  the 
sinking  fund  reserves  has  only  recently  come  into  prominence, 
and  is  now  almost  without  exception  restricted  to  the  sinking 


XIII]  PAYMENTS  ON  BORROWED  CAPITAL  149 

funds  of  large  public  service  open-end  mortgage  bond  issues. 
The  only  objection  to  it  is  the  possibility  of  flagrant  abuse. 
Consequently  the  method  of  investing  the  sinking  fund  in 
the  very  bonds  they  are  supposed  to  protect  is  to  be  preferred 
over  the  investment   in   property   improvements. 

Serial  Bonds. — Closely  allied  with  the  method  of  preparing 
to  redeem  bonds  during  their  life  by  means  of  a  sinking  fund, 
is  the  method  of  actually  redeeming  them  through  the  serial 
maturity  of  a  part  or  the  whole  of  the  issue.  This  plan,  by 
which  a  certain  series  of  the  bonds  of  an  issue  automatically 
mature  each  year,  has  been  adopted  universally  for  equipment 
obligations  and  to  a  very  large  extent  for  timber  bonds, 
although  it  is  much  less  frequently  found  among  corpora- 
tions than  among  municipal  bond  issues.  It  occurs,  however, 
with  perhaps  increasing  frequency  as  its  advantages  are  fully 
realized.  These  advantages,  from  the  point  of  view  of  the 
corporation,  consist  of  the  gradual  cancellation  of  a  part  or 
the  whole  of  the  issue  during  its  life,  without  the  payment 
of  a  redemption  premium,  and  a  wide  market  for  its  bonds 
among  both  banks  which  buy  short-term  bonds  and  investors 
who  buy  medium-  and  long-term  bonds.  The  advantage  to 
the  investor  of  the  instalment  bonds  is  the  assurance  that  a 
part  of  the  issue  will  be  paid  off  before  maturity  without  the 
complication  and  frequently  equivocal  administration  of  the 
sinking  fund.  Also,  owing  to  the  wide  variety  of  maturing 
dates,  the  investor  has  the  privilege  of  selecting  the  time  at 
which  his  bonds  fall  due.  Another  device,  very  uncommon  but 
effectual,  is  for  the  corporation  to  pay  a  certain  sum  each  year 
toward  the  principal  of  each  bond.  In  this  way,  each  bond- 
holder is  paid  a  part  of  his  claim  before  it  is  due,  while  the 
security  behind  the  bonds  remains  the  same. 


CHAPTER  XIV 

THE  CORPORATE  SURPLUS 

Sources  of  the  Surplus — i.  Earnings. — At  this  point  it 
may  be  convenient  to  summarize  the  conclusions  of  the  preced- 
ing chapters.  Gross  profits  represent  the  difference  between  the 
total  receipts  of  a  corporation  and  the  total  expenditures  in- 
curred by  the  actual  conduct  of  its  business.  Net  profits 
represent  what  remains  of  gross  profits  after  the  appropriate 
reductions  are  made  for  maintaining  the  full  economic  value 
of  the  plant  and  equipment  used  in  the  enterprise.  From  the 
net  profit  it  is  necessary  to  subtract  the  cost  of  all  capital 
not  owned  by  the  corporation  itself,  or  to  add  the  receipts 
for  the  use  of  such  of  the  corporation's  capital  as  is  employed 
in  other  enterprises.  The  remainder  may  be  regarded  as 
the  surplus  belonging  to  the  corporation  itself — its  gain  from 
the  year's  business.  Out  of  this  corporate  surplus  certain 
reserves  may  be  set  aside.  What  then  remains — the  stock- 
holders' surplus — may  be  distributed  among  the  stockholders 
in  such  a  manner  and  under  such  conditions  as  may  seem  ex- 
pedient to  the  directors.  The  immediately  succeeding  chapters 
deal  with  questions  of  financial  policy  determining  the  wise 
distribution  of  the  corporate  and  stockholders'  surplus.  This 
policy  involves  more  than  the  simple  question  of  the  amount 
of  dividend  that  shall  be  paid  to  stockholders.  It  involves 
the  broader  question  of  the  best  use  to  be  made  of  the  corpora- 
tion's net  profits,  particularly  so  far  as  the  distribution  of 
the  surplus  affects  the  general  credit  of  the  corporation. 

2.  Paid-in  Surplus. — The  surplus  itself  may  come  from 
other  sources  than  the  profits  of  the  year  immediately  pre- 

150 


XIV]  THE  CORPORATE  SURPLUS  15 1 

ceding.  It  may  be  paid  in  by  the  stockholders  directly  at 
the  beginning  of  the  business.  It  may  arise  through  the  sale 
to  either  stockholders  or  the  public  of  stock  or  bonds  at  a 
premium  above  the  par  value.  It  may  arise  through  the  sale 
of  capital  accounts  for  an  amount  in  excess  of  their  book 
value,  or  the  value  at  which  they  are  carried  in  the  plant  or 
property  accounts.  It  may  arise  through  the  reappraisal  or 
physical  valuation  of  the  assets  of  the  company.  And,  lastly, 
it  may  arise  through  the  accumulation  of  successive  annual 
profits.  This  last  is  the  ordinary  method  under  which  surplus 
arises. 

The  surplus  is  seldom  paid  in  directly  by  stockholders, 
except  in  the  case  of  the  organization  or  reorganization  of 
banking,  insurance,  or  investment  companies.  At  least  a 
moderate  surplus  must  be  shown  on  the  balance  sheet  of  such 
a  company  to  give  an  appearance  of  strength,  so  that  its 
financial  statement  may  inspire  confidence.  The  laws  of  many 
states  also  require  banking  companies  to  accumulate  a  surplus 
above  liabilities  which  shall  not  be  used  for  the  payment  of 
dividends.  By  subscribing  this  surplus  at  the  beginning,  the 
stockholders  may  draw  dividends  on  the  capital  stock  after 
the  first  year  of  business.  Furthermore,  at  a  critical  time 
in  the  history  of  a  bank  or  insurance  company  the  stockholders 
are  frequently  required  to  subscribe  to  the  surplus  in  order 
to  maintain  the  unquestioned  credit  of  the  company.  A  good 
illustration  of  this  is  afiforded  by  the  experience  of  a  large 
insurance  company  directly  after  the  San  Francisco  fire.  The 
Hartford  Fire  Insurance  Company  had  at  the  time  a  capital 
stock  of  $1,250,000  and  an  admitted  surplus,  above  all  liabili- 
ties, including  legal  reserves  for  outstanding  policies,  of  over 
$5,000,000.  The  stock  with  the  par  value  of  $100  was  quoted 
at  $1,200  a  share.  The  company  paid  out  over  $7,000,000 
to  the  San  Francisco  policyholders.  The  disbursement  of  this 
large  sum,  the  largest  ever  paid  by  any  American  insurance 


152  CORPORATION  FINANCE  I XIV 

company  for  a  single  conflagration,  would  have  used  up  the 
surplus  and  seriously  injured  the  general  credit  of  the  com- 
pany. Only  by  maintaining  this  general  credit  untarnished 
could  the  company  hope  to  maintain  its  business  and  recoup 
itself  for  the  loss.  Accordingly  it  sold  7,500  shares  of 
new  stock  to  its  old  stockholders  for  $500  a  share,  par  value 
$100.  This  transaction  increased  its  admitted  capital  stock 
by  $750,000 — from  $1,250,000  to  $2,000,000 — and  added 
$3,000,000  to  the  surplus.  In  all  such  cases  the  surplus  is 
regarded  to  all  intents  and  purposes  as  a  part  of  the 
capital  stock.  In  no  sense  is  it  a  reserve  for  dividends; 
and  if,  under  extreme  provocation,  the  directors  consent 
to  distribute  a  part  of  the  paid-in  surplus  to  stockholders,  the 
report  of  their  action  does  irreparable  injury  to  the  credit 
of  the  company. 

3.  Sale  of  Stock  at  a  Premium. — When  stockholders  or 
the  public  buy  stock  of  the  corporation  at  a  premium,  the 
money  paid  in  is  in  excess  of  the  liability  created  by  the  issue 
of  the  new  security.  Strictly  speaking,  therefore,  it  is  sur- 
plus. Some  of  the  successful  Massachusetts  lighting  com- 
panies have  large  surpluses  created  in  this  way;  in  one  or  two 
cases  the  amount  of  premium  is  nearly  equal  to  the  outstand- 
ing capital  stock.  The  exact  status  of  this  premium  is  very 
difficult  to  define.  Clearly  it  is  capital  paid  into  the  treasury 
of  the  company  to  be  invested  in  the  property  assets  of  the 
company,  yet  it  does  not  represent  an  acknowledged  liability 
to  stockholders  or  creditors.  From  all  points  of  view  the  issue 
of  stock  at  a  premium,  involving  the  continuation  of  the 
premium  as  a  mere  liability,  is  undesirable.  It  leads  to  contro- 
versy and,  in  the  end,  might  be  merged  with  the  regular 
surplus  account  and  used  for  dividend  disbursements  under 
the  guise  of  unappropriated  surplus.  A  large  premium  surplus 
of  the  New  Haven  Railroad  was  used  in  this  way. 


XIV]  THE  CORPORATE  SURPLUS  153 

4.  Sale  of  Property  Above  Book  Value. — A  fourth  way  in 
which  surplus  may  arise  is  through  the  sale  of  property  at 
a  price  above  its  cost  or  above  the  figure  at  which  it  is  carried 
in  the  plant  account.  In  a  few  noteworthy  cases  book  values 
of  real  estate  have  been  marked  up  to  agree  with  ostensible 
increases  in  value.  Sometimes,  fortunately  not  often,  this  book- 
keeping increase  in  assets  has  been  offset  by  a  corresponding 
increase  in  the  represented  surplus  available  for  dividends, 
and  dividends  have  been  straightway  declared  out  of  it.  Thus 
the  old  United  States  Realty  and  Construction  Company,  in 
the  first  nine  months  of  its  operation,  showed  an  apparent 
profit — including  even  estimated  profits  on  unfinished  build- 
ing contracts — of  $930,000.  It  declared,  however,  $1,215,000 
in  dividends.  To  bridge  the  gap  a  surplus,  created  by  mark- 
ing up  real  estate  by  $487,625,  was  added  to  the  net  earnings. 
Soon  thereafter  the  corporation  had  to  be  reorganized  be- 
cause of  imminent  failure.  But  when  property  is  actually 
sold  at  an  enhanced  price,  the  difference  between  this  amount 
and  the  amount  at  which  it  is  carried  will  appear  immediately 
as  a  realized  asset.  It  must  be  balanced  off  by  a  correspond- 
ing liabihty.     This  will  be  of  the  nature  of  a  surplus. 

There  is  an  old  canon  of  accounting,  much  revered  by 
English  accountants,  that  a  profit  and  loss  balance,  to  be 
available  for  dividends,  must  arise  through  the  regular  and 
orderly  movement  of  the  business.  A  surplus  arising  from 
profit  realized  on  the  sale  of  capital  assets  would  not  therefore 
be  available  for  distribution  to  the  stockholders.  There  are 
substantial  reasons  to  support  this  policy,  but  their  strength 
depends  on  how  close  is  the  connection  between  the  sale  of 
capital  assets  and  the  regular  course  of  the  business. 

Quite  generally,  this  surplus  arises  merely  from  the  sale 
of  miscellaneous  capital  assets  at  larger  prices  than  those  at 
which  they  are  carried  upon  the  books;  they  may  represent 
the  receipts  from  the  sale  of  machinery  which  happened  to 


154  CORPORATION  FINANCE  [XIV 

be  worth  more  than  the  amount  at  which  they  are  carried  less 
their  depreciation.  On  the  other  hand,  the  fact  that  capital 
assets  may  be  sold  at  a  profit  carries  as  its  correlative  fact 
the  presumption  that  other  capital  assets  may  be  sold  at  a 
loss.  The  surreptitious  profit,  therefore,  of  one  set  of  trans- 
actions should  be  retained  merely  as  a  reserve  fund  to  balance 
losses  obtained  from  the  sale  of  other  capital  assets.  Such  a 
capital  surplus  account  serves  as  the  means  of  absorbing  all 
these  untoward  and  embarrassing  but  nevertheless  real  deficits. 
In  brief,  then,  all  bookkeeping  or  actual  profits  arising  from 
the  sale  of  capital  assets  should  be  held  as  a  reserve  to  be  used 
in  extinguishing  all  extraordinary  deficits  attributable  directly 
to  losses  in  the  capital  accounts. 

The  misfortunes  resulting  from  not  having  a  surplus 
reserve  account  to  absorb  extraordinary  and  unforeseen  capital 
losses  is  illustrated  by  the  experience  of  the  New  York,  New 
Haven  and  Hartford  Railroad  in  the  year  ending  June  30, 
1 91 4,  the  year  before  the  Great  War,  and  so  presenting  no 
abnormal  conditions.  The  New  Haven  Railroad  started 
July  I,  1913,  with  a  surplus  of  $8,000,000  (using  even  figures) 
accumulated  from  the  previous  annual  profits  of  the  railroad 
business.  After  allowing  inadequate  maintenance  charges  and 
totally  insufficient  depreciation  charges  on  its  equipment 
(2  per  cent,  for  example,  on  steam  and  electric  locomotives — 
fifty  years  of  life),  the  year  showed  a  profit  of  $270,000 
out  of  direct  corporate  revenue  of  $74,000,000.  By  trans- 
ferring certain  funds  and  adjustments  to  the  credit  of  profit 
and  loss  the  company  was  able  to  show  a  bookkeeping  surplus 
of  $10,000,000.  Out  of  this  it  paid  $2,350,000  in  dividends, 
approximately  ten  times  the  admitted  legitimate  earnings  of 
the  year,  and  charged  off  $6,000,000  of  miscellaneous  losses, 
mostly  from  operation  covering  capital  losses.  The  capital 
losses  of  this  one  year  extinguished  the  surplus  accumulations 
of  over  forty  years  of  business. 


XIV]  THE  CORPORATE  -<5URPLUS  155 

5.  Reorganization  of  Financial  Structure. — Another  way 
in  which  a  surplus  may  enter  the  books  of  account  is  through 
the  readjustment  or  reorganization  of  a  corporation's  finan- 
cial structure,  or  through  the  direct  and  explicit  purchase  of 
one  corporation's  assets  by  another.  In  other  words,  a  surplus 
sometimes  arises  through  the  accounting  adjustments  incident 
to  the  organization  of  a  new  corporation.  Sometimes  a  new 
company  takes  over  the  going  businesses  of  several  smaller  com- 
panies. For  these  smaller  companies  a  smaller  par  value  of 
stocks,  bonds,  and  notes  is  paid  than  the  actual  amount  of  the 
assets  acquired.  The  new  corporation  does  not  want  to 
mark  down  these  assets,  especially  if  it  conducts  a  public 
utility  business,  so  that  it  must  set  up  a  fictitious  bookkeeping 
liability  which  assumes  the  nature  of  a  surplus.  A  similar 
situation  arises  when  a  corporation  organizes  a  subsidiary 
to  acquire  property  which  hitherto  had  not  entered  the  books 
of  account  as  assets  or  even  as  property  values.  This  is  true 
when  a  coal  mine  disposes  of  its  waste  "dust"  theretofore 
considered  of  no  value,  or  when  a  chemical  industry  organizes 
a  subsidiary  to  use  up,  at  a  profit,  some  by-product  theretofore 
regarded  as  valueless. 

Investment  of  the  Surplus. — The  surplus  of  a  corporation 
is  kept  entirely  in  the  form  of  actual  money  only  in  extreme 
cases.  The  proportion  that  should  remain  in  bank  deposits 
and  readily  realizable  cash  items  will  depend  on  the  nature  of 
the  business  and  the  frequency  or  nearness  of  sudden  cash  de- 
mands. The  surplus  of  certain  corporations,  notably  insur- 
ance companies,  is  of  the  nature  of  a  trust  fund  which  must 
be  kept  inviolable  to  meet  unforeseen  demands.  Preparation 
to  meet  unexpected  losses  is  the  very  nature  of  the  insurance 
business.  Under  most  circumstances  the  ordinary  receipts 
take  care  of  the  ordinary  disbursements,  but  at  the  time  of  a 
conflagration  the  surplus  must  be  encroached  upon,  since  the 


156  CORPORATION  FINANCE  f  XIV 

customary  reserves  are  insufficient.  That  is  the  reason  why 
an  insurance  company  should,  irrespective  of  its  theories  of 
investment,  keep  a  large  part  of  its  surplus  invested  in  short- 
time  loans  or  listed  securities  easily  liquidated.  Other  cor- 
porations, notably  railroads,  need  not  have  a  single  cent  of  their 
surplus  in  cash  or  easily  realizable  securities.  There  are  no 
sudden  contingenies  which  belong  to  the  nature  of  the  business, 
no  sudden  liabilities  which  can  be  liquidated  only  by  money. 
And  although  in  the  long  run  the  insurance  business  is  no 
more  hazardous  than  the  railroad,  the  former  is  forced  by  its 
peculiar  nature  to  regulate  the  investment  of  its  surplus  as  if 
the  unexpected  were  the  expected. 

The  great  majority  of  businesses,  such  as  all  industrials, 
public  utility  enterprises,  even  most  banks,  should  invest  the 
surplus  where  the  return  is  largest.  This  is  in  the  business 
itself.  The  stockholders  presume,  and  this  presumption  should 
be  true  if  the  business  is  successful,  that  the  officials  can 
invest  the  surplus  in  their  own  business  better  than  in  another 
of  which  they  know  next  to  nothing.  They  cannot  take  the 
surplus  and  invest  it  in  open-market  securities,  for  the  reason 
that  being  engaged  in  a  business  requiring  in  itself  careful 
attention  to  details,  a  close,  careful  attention  to  the  stock 
market  is  the  last  thing  that  should  be  demanded  of  them. 
And  if,  led  by  a  foolish  and  childish  conservatism,  they  invest 
their  surplus  in  high-grade  securities,  such  as  municipal  and 
government  bonds,  they  are  taking  a  lower  rate  of  return  than 
the  money  invested  in  their  own  business  ought  to  bring;  if 
this  be  not  so,  the  business  should  be  liquidated  and  the 
services  of  the  officers  dispensed  with. 


CHAPTER  XV 

INSURANCE  AND  SPECIAL  RESERVES 

The  Necessity  for  Special  Reserves. — Of  the  various 
sources  of  surplus,  one  and  only  one  may  give  rise  to  that  sur- 
plus from  which  dividends  may  be  disbursed.  This  is  the 
surplus  arising  from  the  normal  annual  accumulations  from  the 
profit  and  loss  accounts.  It  is  the  surplus  coming  directly  from 
the  profits  of  the  business.  The  question  of  financial  policy 
in  connection  with  this  surplus  is  the  one  of  dividend  ex- 
pediency— the  proportion  of  surplus  that  must  be  retained  in 
the  business  as  special  or  undefined  reserves  and  the  proportion 
that  may  wisely  be  distributed  to  the  stockholders. 

Theoretically  speaking,  the  surplus  remaining  after  the  pay- 
ment of  interest  and  other  capital  charges  belongs  to  the  stock- 
holders and  might  be  entirely  distributed  in  dividends,  were  the 
directors  so  inclined.  Except  in  extreme  cases  this  is  not  to  be 
considered,  and  even  in  the  extreme  cases  when  it  is  possible, 
there  is  little  to  recommend  such  a  policy.  For  years  the  Boston 
and  Maine  Railroad,  under  the  Tuttle  management,  paid  out 
every  cent  of  surplus  earnings  after  charges,  to  its  stockholders. 
The  ultimate  failure  of  the  Boston  and  Maine  was  the  inevitable 
consequence  of  the  policy.  Were  accountancy  perfect  and  its 
figures  rigid  and  accurate,  especially  those  concerning  deprecia- 
tion and  reserves  for  future  contingencies,  then  the  entire  sur- 
plus might  indeed  be  divided  among  stockholders  with  complete 
equanimity.  But  it  is  not.  It  is  far  less  accurate  than  the 
accountant  deludes  himself  into  believing.  The  practical  busi- 
ness man  knows  this.  He  takes  the  figures  of  the  accountant  as 
sophisticated  guesses  and  directs  his  conduct  on  the  assumption 
that  the  accountant  has  forgotten  not  one  thing,  but  many 

157 


158  CORPORATION  FINANCE  I XV 

things.  He  fortifies  himself  against  these  omissions  of  the  ac- 
countant by  refusing  to  distribute  all  earnings  in  dividends, 
reinvesting  a  part  of  the  surplus  in  betterments  and  improve- 
ments. 

Classification  of  Special  Reserves. — But  it  frequently  hap- 
pens that  some  vague  guess  may  be  made  concerning  at  least  a 
part  of  what  must  be  set  aside  from  current  earnings  to  care 
for  future  contingencies.  These  guesses  are  far  less  accurate 
than  even  the  engineers'  estimates  of  the  life  of  equipment  or 
the  accountants'  computations  of  reserves  for  contingent 
liability  on  discounted  bills.  When  rigidly  analyzed,  the 
reserves  set  aside  to  protect  the  corporation  against  unforeseen 
events  fall  into  four  more  or  less  vaguely  defined  classes.  There 
are  those  reserves  which  must  be  set  aside  for  unpredictable 
taxes,  assessments,  and  special  levies  of  governmental  bodies. 
Such  reserves  are  generally  grouped  together  under  the  head- 
ing "Reserves  for  Taxes."  Second,  there  are  those  reserves 
which  must  be  set  aside  to  care  for  unusual  destructions  to 
physical  property.  Such  reserves  may,  in  a  large  measure,  be 
omitted  if  ample  insurance  of  every  variety  is  carried.  On  the 
other  hand,  if  the  corporation  carries  its  own  insurance,  as  is 
done  in  many  cases,  the  reserves  set  aside  in  lieu  of  the  payment 
of  insurance  premiums  come  under  this  head.  Third,  reserves 
should  be  set  aside  to  care  for  unremunerative  expenses  in- 
volved in  meeting  unforeseen  demands  of  the  public.  Such 
reserves  are  of  most  significance  among  public  service  corpora- 
tions likely  to  be  confronted  with  demands  for  the  elimination 
of  grade  crossings,  smoke  nuisance,  for  burying  wires,  or  for 
repaving  the  right  of  way.  None  of  these  increase  appreciably 
either  the  gross  or  the  net  earnings  of  the  corporation.  Lastly, 
a  corporation  may  wisely  set  aside  reserves  to  care  for  sudden 
and  unavoidable  fluctuations  in  the  economic  demand  for  its 
product,  or  the  availability  of  its  raw  material — panics,  booms 


XVI  INSURANCE  AND  SPECIAL  RESERVES  159 

accompanied  by  scarcity  of  labor,  protracted  business  depres- 
sions. 

1.  Reserves  for  Taxes. — Reserves  for  taxes  do  not  ordin- 
arily lead  to  confusion.  Taxes  are  in  part  known  before  the 
period  during  which  they  accrue,  and  in  part  not.  In  cases 
like  franchise  taxes,  excise  taxes,  pole  taxes,  they  are  known 
in  advance  and  may  be  accurately  apportioned.  Such  taxes  are 
a  direct  operating  expense  and  a  discussion  of  them  is  out  of 
place  at  this  point.  But  there  are  other  kinds  of  taxes  which 
are  only  to  be  apportioned  approximately ;  and  in  unusual  cases 
the  corporation  must  make  reserves  against  the  payment  of 
taxes  the  amount  and  the  principles  of  levying  of  which  can- 
not be  even  vaguely  guessed  at.  The  excess  profits  tax  for 
the  year  1918,  not  determined  by  Congress  until  February, 
1919,  was  of  this  description.  It  is  these  various  unpredictable 
and  often  undetermined  levies  which  the  corporation  must 
protect  itself  against,  by  special  reserves  for  taxes. 

The  fiscal  year  of  the  company  and  of  the  tax  assessor  may 
not  coincide  and  it  will  be  necessary  to  set  aside  a  reserve  to 
care  for  any  difiference  in  assessment  or  when  a  corporation 
protests  a  new  assessment  in  the  courts. 

2.  Reserves  for  Property  Destruction. — The  second  large 
class  of  special  reserves  that  must  be  set  aside  for  the  general 
surplus  are  those  having  to  do  with  protection  against  unusual 
and  unforeseen  losses  to  property.  Ordinarily  such  losses  are 
carried  by  insurance,  and  the  insurance  premiums,  like  taxes, 
are  charged  directly  against  the  gross  receipts  as  one  of  the 
direct  expenses  of  the  business.  Under  certain  circumstances, 
however,  special  and  somewhat  unusual  precautions  must  be 
taken  either  in  addition  to  the  regular  provisions  for  insurance 
or  else  in  lieu  of  the  regular  forms  of  insurance.  Ordinary  fire 
insurance  policies  can  be  secured  when  the  corporation's  pro- 


l6o  CORPORATION  FINANCE  [XV 

perty  consists  of  buildings  and  structures;  such  insurance, 
especially  when  distributed  among  several  underwriting  com- 
panies, may  be  relied  upon  as  adequate  provision  against  the 
hazard  of  fire.  It  is  possible  also  for  the  corporation  to  protect 
itself  against  incidental  losses  occasioned  by  fire,  such  as  loss 
of  revenue  during  reconstruction  or  penalties  under  breach  of 
contract  to  deliver  finished  goods.  In  the  majority  of  cases, 
however,  a  corporation  will  not  take  out  such  insurance  to 
protect  it  against  these  contingent  hazards  because  of  the  great 
expense  and  the  difficulty  of  determining  the  conditions  and 
adjusting  the  claim  in  cases  of  loss  under  the  policy.  Yet  in 
very  many  businesses,  reserves  must  be  set  aside  for  losses  of 
just  such  kinds.  Contracts  often  call  for  delivery  of  merchan- 
dise within  time  limits,  a  break  of  which  involves  severe 
penalties.  In  case  of  fire  it  may  be  necessary  to  operate  night 
shifts  at  great  additional  expense  or  else  go  into  the  market 
and  pay  premiums  for  the  quick  delivery  of  goods,  in  order  to 
avoid  the  heavier  losses  resulting  from  a  broken  contract.  In 
brief,  many  incidental  losses  are  possible  which  are  not,  and 
in  many  cases  cannot,  be  guarded  against  by  the  ordinary  forms 
of  insurance. 

Self-Insurance  by  Corporations. — The  purpose  of  insur- 
ance is  to  distribute  unusual  losses  by  shifting  the  burden  from 
one  individual  to  a  large  number  of  individuals.  The  insurance 
company  justifies  itself  economically  by  supplying  the  clearing 
house  and  effecting  the  distribution  of  the  losses.  But  when 
the  corporation  owns  a  large  enough  aggregate  of  individual 
pieces  of  property  so  that  it  can  itself  effect  a  distribution  of 
the  risks  and  the  "clearing"  of  the  losses,  it  can  well  save  the 
cost  of  the  machinery  of  operation  of  the  insurance  company, 
amounting  usually  to  at  least  half  the  ordinary  premiums. 
This  can  be  done  if  the  corporation  charges  itself  the  ordinary 
premiums,  setting  aside  the  amounts  in  a  separate  fund  into 


XV]  IN.SURANCE  AND  SPECIAL  RESERVES  l6l 

which  are  brought  all  the  premiums  and  from  which  are 
drawn  all  the  losses.  And  if  the  nature  of  the  corporation's 
physical  property  is  such  as  to  meet  the  certain  conditions 
— property  consisting  of  small,  separate,  and  relatively  in- 
expensive units — it  is  probable  that  the  corporation  will,  in  the 
long  run,  profit  from  its  insurance  account.  For  since  a  con- 
siderable portion  of  the  premium  is  represented  by  the  ordinary 
expenses  of  operating  the  insurance  company,  which  the  cor- 
poration which  follows  the  plan  of  self -insurance  does  not  have 
to  pay,  such  a  corporation  will  create  for  itself  within  its  own 
Insurance  reserve  a  kind  of  insensible  reserve  which  will,  as 
soon  as  a  considerable  fund  has  been  established,  fortify  the 
normal  reserve  against  unusual  losses. 

Railroads  are  particularly  well  suited  to  carry  their  own  in- 
surance. Except  for  their  urban  terminals  no  single  hazard 
amounts  to  much  and  the  total  annual  fire  losses  on  a  single 
system  are  small  compared  to  the  total  property  or  the  total 
income.  Certain  data  concerning  the  experience  of  the  New 
York,  New  Haven  and  Hartford  Railroad  in  their  insurance 
accounts  bear  this  out.  During  the  seven  years  preceding  June 
30,  191 5,  the  average  annual  income  of  the  New  Haven  Rail- 
road (not  including  its  allied  enterprises)  was  $63,200,000. 
Its  fire  loss  averaged  $140,000  a  year,  or  about  2/10  per  cent. 
The  year  ending  June  30,  191 5,  is  probably  fairly  typical.  The 
gross  income  was  $65,379,264.  There  were  247  separate  fires, 
involving  a  loss  of  $60,000,  or  only  $243  for  each  fire.  The 
New  Haven's  burnable  property  was  estimated  at  $85,000,- 
000.  The  fire  loss  for  this  year  was  therefore  only  i/io  per 
cent  of  the  gross  income  and  less  than  i/io  per  cent  of  the 
total  burnable  property. 

Outside  of  the  fire  hazard  the  practice  has  been  used  with 
profit  by  corporations  engaged  in  the  shipping  business, 
especially  when  the  corporation  owns  a  fleet  of  small,  relatively 
"nexpensive  ships.     This  policy  of  self-insurance  should  under 


J62  CORPORATION  FINANCE  [XV 

no  circumstances  be  followed  by  corporations  owning  a  few 
vessels,  because  sufficient  distribution  of  risks  cannot  be 
obtained. 

When  the  corporation  owns  forest  property  that  cannot  be 
insured  a  reserve  for  the  fire  hazard  should  be  set  aside  directly 
from  the  general  surplus.  This  is  very  important  with  paper 
and  tanning  companies  owning  their  own  woodlands. 
Ordinarily  wages  of  fire  wardens  and  rangers  would  be  a 
direct  charge  to  operation.  But  this  kind  of  protection  is  not 
enough,  especially  if  the  corporation  has  a  considerable  pro- 
portion of  its  assets  invested  in  timber  lands.  True,  a  reserve 
could  not  be  set  aside  compatible  with  the  premiums  that  a  fire 
insurance  company  would  feel  compelled  to  charge  on  timber 
property,  but  some  regular  appropriation  based  on  the  cost  of 
the  stumpage  must  be  set  aside,  else  losses  resulting  from  forest 
fires  will  be  direct  capital  losses.  Unless  the  corporation  is 
fortified  in  some  other  direction  such  an  unprotected  loss  may 
seriously  affect  the  corporation's  solvency. 

Investment  of  Insurance  Reserves. — It  is  obviously  reason- 
able that  the  special  insurance  reserve  and  the  ordinary  insur- 
ance reserves  resulting  from  the  accumulation  of  annual 
allotments  from  earnings  should  under  no  circumstances  be 
invested  in  property  subject  to  the  same  hazard  as  the  property 
for  the  replacement  of  which  the  fund  is  maintained.  A  ship- 
ping corporation,  for  example,  carries  its  own  insurance.  As 
a  result  of  this  policy,  $2,000,000  has  been  accumulated  from 
premiums  with  which  the  corporation  has  charged  itself,  and 
in  addition  it  has  set  aside  $50,000  a  year  for  ten  years  from 
its  general  profit  and  loss  surplus  to  care  for  "war  or  other 
unusual  losses."  It  is  evident  that  these  two  funds  should  not 
be  invested  in  any  kind  of  property  subject  to  the  marine 
hazard.  If  the  railroad  corporation  insures  its  own  stations, 
the  fund  should  not  be  invested  in  station  property;  if  a  grain 


XV]  INSURANCE  AND  SPECIAL  RESERVES  163 

company  insures  its  own  elevators,  then  the  reserve  is  not  10 
be  placed  in  elevator  property.  This  policy  must  be  rigidly  and 
scrupulously  followed,  else  the  whole  principle  of  insurance 
reserves  breaks  down.  And  it  is  difficult  to  observe.  Most 
business  men  are  familiar  only  with  their  own  or  allied  busi- 
nesses, seldom  with  the  general  investment  business.  More- 
over, if  the  insurance  reserve  funds  accumulate  in  considerable 
amounts  there  is  always  a  temptation  to  use  the  money  for 
the  general  purposes  of  the  corporation,  where,  unquestionably, 
it  will  earn  more  than  in  low-interest-paying  readily  marketable 
securities.  The  latter  are  the  only  wise  media  for  insurance 
reserve  investments.  A  desirable  arrangement  is  about  one- 
fourth  of  the  fund  in  bank  certificates  of  deposit  payable  30 
or  at  most  90  days  from  demand,  one-fourth  in  active,  listed 
first  mortgage  railroad  bonds,  and  the  other  half  in  municipal 
and  government  securities.  If  such  an  arrangement  is  followed 
little  care  will  need  to  be  exercised  by  the  treasurer  of  the 
corporation  in  the  investment  field  with  which  he  is  unfamiliar, 
and  a  large  proportion  of  the  fund  will  be  immediately  realiza- 
ble in  cash  if  unusual  losses  make  demands  upon  the  fund. 

Because  a  plant  in  working  order  is  essential  to  the  conduct 
of  any  business  and  because  fire  hazards  are  within  the  range 
of  probability,  the  reserves  set  aside  for  insurance,  to  be  used 
only  for  plant  rehabilitation,  must  be  kept  invested  outside  the 
risks  of  fires  incident  to  the  business.  They  must  be  available 
at  any  time.  Under  no  circumstances  should  they  be  treated 
as  ordinary  surplus  reserves  which  may  be  invested  in  the  busi- 
ness. The  insurance  reserve  fund  investments  of  the  United 
Fruit  Company,  for  example,  were  carried  in  large  proportion 
in  "high-grade  first  mortgage  railroad  bonds."  Through  a 
series  of  years,  from  1901  to  1914,  the  company  averaged  over 
10.7  per  cent  the  capital  invested  in  its  regular  business;  but 
owing  to  the  necessity  of  holding  the  fund  in  liquid  form,  it 
realized  only  4.3  per  cent  on  its  insurance  reserve. 


1 64  CORPORATION  FINANCE  I  XV 

3.  Reserves  for  Unremunerative  Improvements. — A  third 
set  of  reserves  must  be  set  aside  to  meet  the  large  expenses  in- 
curred in  complying  with  changed  social  and  public  require- 
ments. There  may  be  considered  unproductive  or  unre- 
munerative improvements.  They  represent  the  costs  incident 
to  complying  with  a  more  enlightened  social  consciousness, 
either  in  the  direction  of  greater  safety,  greater  convenience 
of  the  public,  a  keener  social  morality,  or  even  a  more  critical 
sense  of  communal  beauty  and  fitness.  As  a  class  the  expenses 
are  very  numerous — ornamental  street  lights,  fire  escapes, 
automatic  signals,  "welfare"  improvements,  "full  crew"  laws, 
contributions  to  hospitals  and  public  improvement  funds. 
When  these  expenses  are  individually  small  they  are  merely 
charged  against  the  ordinary  costs  of  operations  and  require 
no  further  comment.  But  certain  of  them  are  very  large,  such 
as  elimination  of  grade  crossings,  paving  between  tracks,  bury- 
.ing  of  wires,  extensive  ornamental  lighting  systems,  elimina- 
tion of  smoke,  fumes,  and  odors.  These  are  all  unprofitable, 
in  the  view  of  the  corporation's  system  of  accounting,  in  that 
they  do  not  lead  to  an  increase  of  earnings.  The  only  logical 
method  of  treating  such  expenditures  is  that  of  creating  a 
reserve  fund  for  them  through  annual  appropriations  from  the 
general  surplus.  The  obvious  difficulty  in  making  these  ap- 
propriations is  the  evident  uncertainty  of  the  cost  and 
frequency  of  such  unprofitable  improvements.  This  difficulty 
is  unquestionably  real,  but  it  can  hardly  be  advanced  against 
the  wisdom  of  the  policy.  This  idea  is  admirably  expressed 
by  an  engineer  referring  especially  to  traction  companies : 

Every  company  occupying  public  ways  is  confronted  with 
the  certainty  that  they  will  be  compelled  to  make  costly  changes 
of  plant  owing  to  changes  made  in  state  or  municipal  regula- 
tions. It  is  proper  that  a  company  should  make  annual 
appropriations  to  provide  funds  to  meet  obligations  arising  from 
such  causes. 


XVI  INSURANCE  AND  SPECIAL  RESERVES  165 

The  question  naturally  arises  as  to  whether  some  of  the 
cost  of  the  unprofitable  improvements  may  not  wisely  be 
written  off  during  a  term  of  years  following  the  completion  of 
the  enterprise.  If  such  a  policy  be  followed  it  will  be  necessary 
to  carry  forward  a  part  of  the  cost  as  deferred  asset,  to  be 
gradually  extinguished  during  the  term.  Such  a  policy  may 
have  the  advantage  of  being  more  certain  and  definite  in  its 
demands  than  that  of  creating  a  reserve  fund,  but  it  has  the 
glaring  defect  of  throwing  the  entire  expense  into  a  relatively 
short  period  or  prolonging  indefinitely  the  deferred  asset. 
Moreover,  since  the  cost  cannot  be  transferred  onto  the 
shoulders  of  the  community  by  an  increase  of  rate,  in  the  case 
of  a  public  utility,  it  is  probable  that  the  period  following  the 
improvement  is  no  better  able  to  bear  the  expense  than  the 
preceding  period.  Were  it  possible  to  increase  the  rates  for 
service  or  otherwise  increase  the  earning  power  of  the  corpora- 
tion by  reason  of  the  improvement — as  water  companies  some- 
times do  on  the  erection  of  a  filtering  plant — the  improvement 
would  not  be  unprofitable  and  hence  would  be  outside  the 
present  category. 

4.  Reserves  for  Business  Uncertainties. — The  last,  and 
in  a  sense  the  vaguest,  group  of  special  reserves  that  should 
be  set  aside  from  the  general  surplus  is  that  to  care  for 
abrupt  changes  in  the  demand  for  the  product.  It  is  certain, 
however,  that  when  large  earnings  have  resulted  from  abnormal 
conditions  which  are  of  a  relatively  temporary  character  and 
over  which  the  management  can  maintain  no  control,  some 
reserve  must  be  set  aside  to  fortify  the  corporation  against 
losses  when  conditions  become  unusually  unfavorable.  Difficult 
as  it  is  to  determine  any  average  reserve  that  must  be  set  aside 
in  abnormally  prosperous  years,  it  is  even  more  difficult  to 
determine  under  what  conditions  such  a  reserve  should  be 
utilized.     Clearly  the  purpose  of  setting  aside  the  reserve  in 


l66  CORPORATION  FINANCE  [XV 

the  prosperous  years  is  to  afford  a  fund  to  equalize  the  ex- 
cessive production  costs  or  even  the  deficits  during  years  of 
abnormally  small  earnings.  But  what  shall  be  the  criterion 
which  shall  determine  whether  or  not  a  bad  year  is  so  bad  as  to 
permit  the  management  to  draw  on  this  reserve  to  offset  its 
losses?  There  is  no  infallible  foresight.  No  invariable  rule 
can  be  laid  down,  and  even  if  it  could  the  decision  in  any  given 
case  is  linked  with  other  matters  of  general  financial  policy, 
such  as  the  need  for  maintaining  the  credit  of  the  corporation 
and  the  general  dividend  policy. 

Perhaps  the  most  good  that  such  a  reserve  can  accomplish 
is  the  psychological  influence  exerted  on  the  directors  and  the 
stockholders  by  the  recognition  and  acknowledgment  of  the 
principle  that  abnormally  large  earnings  are  almost  invariably 
coupled  with  abnormally  small  earnings.  The  admission  of 
this  general  economic  principle  must  act  as  a  deterrent  to 
prevent  the  dissipation  of  assets  by  the  payments  of  excessive 
dividends  or  the  unwarranted  expenditures  for  new  construc- 
tion. The  losses  of  many  corporations  in  the  depression  fol- 
lowing immediately  after  the  Great  War  were  in  some  cases  so 
great  as  to  extinguish  not  only  the  large  war  profits  but  also 
the  accumulated  reserves  of  a  lifetime.  The  automobile  tire 
companies  lost  more  in  the  sudden  decline  of  their  inventories 
than  they  had  made  during  the  war;  several  would  have  been 
forced  to  confess  bankruptcy  had  it  not  been  for  the  saving 
help  accorded  them  by  bankers.  During  a  period  of  twenty 
odd  years  the  Quaker  Oats  Company  accumulated  a  surplus 
which  stood  at  $5,300,000  on  January  i,  1920.  This  was 
practically  all  extinguished  by  losses — chiefly  in  inventories 
and  unwise  commitments — during  the  last  four  months  of 
1921. 


CHAPTER  XVI 

STOCKHOLDERS'    SURPLUS 

The  Principle  of  Dividend  Disbursement. — That  which 
remains  of  net  profits  after  all  interest  charges  have  been  met 
and  all  special  reserves  set  aside  may  be  used  by  the  stockholders 
as  their  directors  see  fit.  It  may  be  called  the  "stockholders' 
surplus."  The  directors  must,  however,  determine  what  pro- 
portion of  this  surplus  should  be  paid  over  to  the  stockholders. 
Many  and  varied  considerations  tend  to  influence  the  directors 
in  determining  the  proportion  of  the  total  net  surplus  that  may 
expediently  be  distributed  among  the  stockholders  and  the  pro- 
portion that  should  be  kept  in  the  business.  This  question  is  in 
the  end  not  one  of  the  theory  of  accounts  or  of  business  law 
or  even  of  universally  applicable  financial  principles.  It  is 
purely  one  of  individual  business  expediency. 

Underlying  this  principle  of  business  expediency,  as  an 
inflexible  rule,  is  the  clearly  established  principle  of  law  and 
finance  that  dividends  may  not  be  declared  out  of  capital.  The 
law,  apparently,  interprets  capital  somewhat  roughly  and  does 
not  rigidly  insist  that  proper  depreciation  charges  shall  be  set 
aside  before  computing  net  profits.  But  it  has  made  it  clear 
that  there  cannot  be  a  direct  payment  of  dividends  in  excess 
of  what  we  have  here  called  "gross  profits."  Further  than  this 
there  is  absolutely  no  statutory  or  other  principle  of  law  that 
determines  or  even  concerns  itself  with  the  proportion  of  the 
gross  or  net  earnings  that  may  be  paid  to  stockholders. 

Avoidance    of    Misrepresentation There    is    no    other 

principle  of  law,  one  ought  to  add,  except  the  principle  of  law 
and  common  morality  that  the  declaration  of  dividends  should 

167 


1 68  CORPORATION  FINANCE  [XVI 

not  be  based  on  misrepresentation,  as  when  earnings  are  over- 
stated, in  order  to  present  an  accounting  justification  for  the 
payment  of  unearned  dividends.  It  is  unnecessary  to  state  that 
unearned  dividends  shall  not  be  paid  to  vindicate  a  bad 
management,  to  maintain  the  market  price  of  a  company's 
stocks,  or  to  maintain  the  legality  of  the  company's  bonds 
among  savings  banks,  or  to  sell  bonds  at  a  higher  price  than 
actual  earnings  would  justify. 

In  the  past  many  railroads  have  been  guilty  of  such  deceits : 
and  one  of  the  clearly  apparent  advantages  of  a  uniform  system 
of  railroad  accounting  has  been  to  make  this  particular  species 
of  misrepresentation  more  obvious  and  more  certain  of  dis- 
covery. But  another  kind  of  misrepresentation  sometimes 
indulged  in  is  that  of  withholding,  by  the  directors,  of  informa- 
tion concerning  dividend  action.  The  most  notorious  case  of 
this  kind  is  that  of  the  action  of  the  Union  Pacific  Railroad's 
directors  in  August,  1906.  By  reason  of  large  hidden  earnings 
of  the  Union  Pacific's  subsidiary,  the  Southern  Pacific,  the 
latter  came  in  the  summer  of  1906  into  a  position  to  pay 
dividends  into  the  treasury  of  the  Union  Pacific.  Accordingly 
the  directors  of  the  two  roads  met  simultaneously.  The 
Southern  Pacific  directors  declared  an  initial  dividend  of  2^^ 
per  cent  and  immediately  thereafter  the  Union  Pacific  Rail- 
road's directors  raised  its  semiannual  dividend  from  3  to  5 
per  cent.  But  this  action  was  rigidly  concealed  for  two  days. 
Meanwhile  tremendous  activity  occurred  in  the  market  for 
the  company's  shares.  More  recently  the  directors  of  the  B. 
F.  Goodrich  Company  concealed  a  dividend  action  on  the 
preferred  shares  for  a  period  of  six  weeks.  During  this  period 
the  stock  fell  from  $89  a  share  to  under  $74  a  share.  The 
story  was  told  and  commented  upon  in  the  New  York  Morning 
Post  in  the  following  way : 

On  Wednesday  of  this  week,  in  the  formal  announcement  to 
preferred  shareholders  of  the  B.  F.  Goodrich  Company  that  the 


XVI]  STOCKHOLDERS'  SURPLUS  1 69 

regular  dividend  of  i^  per  cent  had  been  declared  on  their 
stock,  the  statement  was  made  that  this  dividend  was  declared 
six  weeks  ago,  on  October  22.  Harmless  as  the  statement  ap- 
peared to  be,  it  brought  such  serious  criticism  against  directors 
of  the  B.  F.  Goodrich  Company  that  the  extreme  means  of 
punishment  was  suggested  of  removing  the  Goodrich  shares 
from  the  Stock  Exchange  list. 

For,  by  withholding  formal  announcement  of  their  dividend 
action  until  this  week,  directors  of  the  Goodrich  Company 
permitted  the  preferred  shares  to  fall  in  price  from  89  to  73^, 
investors  in  the  company  and  Wall  Street  speculators  selling  the 
stock  through  the  month  of  November  on  rumors  that  the 
dividend  was  to  be  cut  or  passed. 

The  fact  that  no  way  has  been  found  for  punishing  those 
guilty  of  the  Goodrich  episode  has  not  lessened  the  indignation 
that  is  felt  at  the  entire  episode;  rather  it  has  led  to  a  general 
demand  on  the  Stock  Exchange  for  a  rule  that  will  in  future 
make  it  compulsory  for  all  dividend  announcements  to  be  made 
within  forty-eight  hours  after  they  are  declared.  Another  need 
it  has  emphasized  is  that  of  more  and  better  laws  governing 
the  management  of  corporations.  The  Goodrich  incident  has 
uncovered  an  old  condition  wherein  certain  directors  admit  they 
knew  nothing  of  what  other  directors  were  doing.  The  Good- 
rich dividend  was  declared  on  October  22,  at  Akron,  Ohio,  by 
a  quorum  of  the  board.  Not  until  this  week  did  certain  of  the 
other  directors  know  the  dividend  had  been  declared.  Here  is 
a  condition  disclosed  which  clearly  needs  remedying. 

Such  cases  of  direct  or  constructive  misrepresentation  are, 
fortunately,  sporadic  and  call  forth  the  condemnation  they 
deserve.  In  every  direction  there  is  a  growing  demand  that 
extreme  care  be  exercised  that  all  representations  concerning 
earnings  and  dividends  made  by  a  corporation's  directors  to  its 
stockholders  shall  be  not  merely  technically  true  but  implicitly 
and  unequivocally  true. 

Reinvestment  of  Surplus  in  the  Business. — A  noteworthy 
and,  from  the  economic  point  of  view,  a  very  significant  dif- 


170  CORPORATION  FINANCE  f  XVI 

ference  between  various  kinds  of  business  lies  in  the  rapidity 
with  which  the  capital  is  turned  over.  There  are  three  points 
of  view  from  which  this  phenomenon  may  be  analyzed.  One 
is  the  length  of  credit  required  to  safeguard  invested  capital, 
another  is  the  sensitivity  to  changes  in  industrial  conditions, 
and  a  third  is  the  relative  quantity  of  fixed  capital  necessary  to 
meet  the  requirements  of  an  increasing  volume  of  business. 
This  last  is  of  moment  in  this  question  of  dividend  policy. 
A  remarkable  contrast  between  the  great  industrial  combina- 
tions and  the  combinations  in  the  railroad  and  public  service 
fields  lies  in  the  fact  that  a  large  proportion  of  the  former  have 
issued  no  new  securities  since  they  were  promoted.  Indeed, 
instead  of  seeking  new  capital  for  improvements  and  extension 
they  have,  in  very  many  cases,  gradually  absorbed  the  excess  of 
capitalization  that  characterized  their  promotions  through  the 
steady,  almost  unnoticed,  reinvestment  of  earnings  in  improve- 
ments to  their  plants.  Each  has  been,  for  its  capital  require- 
ments, sufficient  unto  itself.  The  expansion  of  the  large 
railroad  systems  and  public  service  enterprises  present  strik- 
ing contrast.  As  their  gross  business  has  increased,  plants 
have  expanded  many  fold.  A  slight  increase  in  their  gross 
income  requires  a  vastly  greater  increase  in  their  investment 
in  permanent  property.  And  this  increase  in  fixed  capital  is  all 
out  of  proportion  to  the  net  earnings  likely  to  arise  immediately 
from  the  enlarged  property  and  the  increased  business. 

The  shoe  manufacturing  business  and  the  hydroelectric 
power  business,  are  perhaps  the  extremes  of  the  series.  In  the 
former  case  the  machinery  is  leased  from  the  United  Shoe  Ma- 
chinery Company — thus  involving  no  capital  investment.  Even 
the  building  or  "shell"  may  be  rented.  As  a  result  the  shoe 
manufacturer  may  plan  to  turn  his  capital  at  least  once  in  two 
months — six  times  a  year.  In  case  a  considerable  proportion 
of  the  capital  required  in  the  business  is  furnished  by  banks 
and  merchandise  creditors,  the  rate  of  turnover  of  the  pro- 


XVI J  STOCKHOLDERS'  SURPLUS  17 1 

prietor's  own  capital  may  be  even  greater.  A  large  hydro- 
electric power  dam  costing  $10,000,000  is  likely  to  earn  about 
$1,000,000  gross  a  year — often  even  less.  It  "turns"  its  capital 
once  in  ten  years.  The  ratio  of  rapidity  of  turning  capital  in 
these  two  industries  is  thus  at  least  60  to  i. 

The  great  importance  of  this  simple  fact  to  questions  of 
dividend  policy  is  that  corporations  which  turn  their  capital 
slowly  should  be  prepared  to  reinvest  earnings  in  their  plants, 
as  the  large  sums  required  for  plant  improvements  cannot  be 
counted  on  for  a  certainty  from  outside  sources.  The  invest- 
ment markets  may  be  suddenly  closed  upon  them  when  they  are 
most  in  need  of  new  capital  and  their  only  recourse  is  to  their 
own  earnings.  During  the  late  summer  and  early  autumn  of 
1914  when  the  hostilities  of  the  European  nations  were  the 
predominating  element  in  all  problems  of  finance,  when  the  ex- 
changes all  over  the  world  were  closed,  and  when  money  in 
large  sums  could  not  be  obtained  by  private  corporations  at 
any  reasonable  price,  many  companies  with  insufficient  money 
in  their  treasuries  to  meet  their  usual  requirements  passed  their 
dividends  in  order  to  maintain  a  kind  of  reserve  in  case  their 
plans  for  new  construction  should  be  interfered  with  by  the 
stringency  of  the  money  market.  This  policy  was  adopted 
by  many  public  service  corporations  which  had  undertaken 
large  extensions  of  plant  without  the  full  amount  of  capital  in 
hand.  Such  a  policy  was  unquestionably  wise  in  view  of  the 
disturbed  conditions  of  the  world's  markets,  but  might  be 
criticized  by  the  stockholders  who  could  easily  persuade  them- 
selves that  the  war  would  be  of  short  duration  and  that  there- 
fore the  stockholders  could  claim  the  full  payment  of  dividends 
as  a  matter  both  of  right  and  expediency. 

Confidence  in  Accounting  Methods. — As  suggested  several 
times  before,  accounting  methods  are  efiforts  to  state  precisely — 
or  rather  with  that  degree  of  precision  figures  make  possible 


172  CORPORATION  FINANCE  (XVI 

— a  set  of  varying,  and  in  many  cases  intangible,  economic 
values.  So  long  as  these  estimates  serve  only  as  checks  to 
actual  conditions,  errors  in  them  are  not  vital.  But  should  they 
mislead  the  judgment  in  distributing  as  net  profit  what  was 
in  truth  capital,  the  consequences  to  the  solvency  of  the  corpora- 
tion would  be  serious.  To  prevent  such  an  overestimation  of 
earnings  it  was  insisted  in  the  preceding  chapter  that  reserves 
for  various  unknown  contingencies  should  be  set  aside.  But  the 
vast  majority  of  corporation  officials  will  not  insist  on  any  such 
sophisticated  precision  regarding  reserves  for  unknown  events. 
They  will  prefer  merely  to  keep  some  of  the  earnings  in  the 
business,  so  that  if  "something  comes  up"  the  corporation  shall 
have  a  bulwark  to  fall  back  upon.  Or,  putting  the  matter  more 
baldly,  most  corporation  ofificials  will  not  insist  that  special 
"earmarked"  reserves  be  set  aside  for  various  unknown  pos- 
sible losses;  but  they  will  insist  that  they  be  given  the  un- 
restricted power  to  determine  the  amount  of  earnings  to  be  kept 
within  their  control  as  a  general  reserve  fund  to  meet  the 
future  vicissitudes  of  trade  and  public  demands — vicissitudes 
which  they  only  vaguely,  but  nevertheless  consciously, 
recognize. 

Furthermore,  in  addition  to  any  possible  losses  which  ac- 
countant and  director  alike  might  anticipate,  it  frequently  hap- 
pens that  there  are  contingent  events  against  which  no  system 
of  accounting,  unless  omniscient,  could  protect  the  corporation. 
In  the  year  ending  December  31,  191 3,  the  express  companies 
were  putting  into  effect  the  new  and  radically  lower  system  of 
rates  established  by  the  Interstate  Commerce  Commission.  No 
one  could  tell  whether  the  cheaper  rates  would  so  affect  the 
use  of  the  express  service  that  the  receipts  under  the  new 
schedules  would  increase  or  decrease  the  net  revenue.  At  first 
there  was  a  distinct  dropping  off  of  earnings.  In  the  case 
of  the  Wells  Fargo  Company  the  total  earnings  during  the 
year  ending  June  30,  191 4,  were  clearly  less  than  the  previous 


XVI]  STOCKHOLDERS'  SURPLUS  173 

dividend  rate.  The  dividend  was  reduced  from  lO  to  6  per  cent 
annually,  although  the  company's  total  earnings  at  the  end  of 
the  year  amounted  to  something  over  9  per  cent.  The  president 
of  the  company  remarked  in  the  report  that  the  express  com- 
panies were  on  trial,  and  that  the  safer  policy  to  pursue  was  to 
reduce  the  dividends  to  well  below  the  total  earnings.  The 
phrasing  of  this  part  of  the  report  is  worth  considering. 

Notwithstanding  the  net  earnings  from  all  sources  for  the 
year  were  nearly  sufficient  to  pay  the  former  rate  of  dividend, 
it  was  apparent  that,  for  the  time  at  least,  the  company's  opera- 
tions should  be  conservatively  regarded  as  passing  through  a 
probationary  period;  and  until  the  earning  possibilities  under  the 
new  conditions  could  be  more  fully  demonstrated,  the  Board  of 
Directors  decided  to  reduce  the  dividend  rate. 

Yet  when  all  is  said,  the  whole  question  of  the  proportion 
of  profits  to  be  retained  in  the  business  must  rest  with  the 
judgment  of  the  directors  themselves.  In  the  end,  it  is  true, 
the  "horse  sense"  of  the  average  corporation  director  will 
prescribe  a  reserve  to  be  "left  in  the  business"  which  will 
approximate — and  quite  often  exceed — the  sum  of  the  various 
reserves  which  the  accountant  would  insist  upon  from  his 
elaborate  sophisticated  guesses.  It  does  not  matter  to  the 
well-being  of  the  corporation  whether  the  proportion  of  earn- 
ings retained  in  the  business  to  safeguard  it  against  the  vicis- 
situdes of  an  unknown  future  is  computed  by  the  laborious 
and  intricate  calculations  of  the  engineer  and  the  accountant, 
guided  by  a  "law  of  averages,"  or  is  merely  guessed  at  by 
shrewd  men  on  the  basis  of  a  long  and  varied  experience  of 
business,  provided  only  the  amount  held  back  be  ample.  And 
it  is  distinctly  to  the  credit  of  the  majority  of  American  busi- 
ness men  who  reach  high  managerial  positions,  that  their 
natural  insight  enriched  by  a  wide  experience  is  sufficient  to 
protect  the  stockholders  against  their  own  avarice  in  demand- 
ing larger  dividends  than  prudence  justifies. 


174  CORPORATION  FINANCE  {XVI 

Regularity  of  Dividends. — Far  more  subtle  is  the  require- 
ment that  dividends  shall  be  constant  and  regular.  It  is  more 
subtle  because  it  depends  on  the  interpretation  of  business 
policy  by  large  groups  of  stockholders  and  by  the  general  pub- 
lic, who,  by  their  approval  or  disapproval,  can  make  or  mar 
the  general  credit  of  the  corporation. 

The  question — already  discussed — of  the  accuracy  of  pre- 
dictions of  earnings  underlies  questions  of  the  regularity  of 
dividends  also.  At  one  extreme  is  a  private  water  company 
the  earnings  of  which  may  probably  be  predicted  within  a 
very  close  margin  of  error.  At  the  opposite  extreme  is  a  manu- 
facturing concern  making  some  specialty  machinery,  where 
earnings  are  subject  to  abrupt,  violent,  and  unpredictable 
fluctuations.  The  specific  solution  of  the  problem,  then,  is 
inherent  in  the  character  of  a  business.  For  that  reason  it 
can  be  discussed  only  with  reference  to  specific  businesses,  and 
this  is  the  task  of  the  succeeding  chapter.  But  the  general 
question  as  to  the  expediency  of  making  regular  dividends  is 
one  which  applies  to  all  corporations. 

This  regularity  of  dividend  payments  helps  the  corporation 
in  two  very  important  respects.  It  creates  a  loyal  group  of 
stockholders  who  hold  their  stock  for  investment  and  not  for 
speculation.  They  have  confidence  that  the  directors  will  not 
give  them  good  cause  for  assuming  that  a  policy  of  regular 
dividends  is  to  be  followed,  and  then  break  the  understanding 
at  the  first  excuse.  It  also  creates  a  strong  credit  to  be  utilized 
for  borrowing  in  the  open  market.  In  the  former  respect  the 
value  of  a  record  of  regular  dividends  can  hardly  be  over- 
estimated. The  common  stocks  of  the  Great  Northern,  the 
Pennsylvania,  the  Chicago  and  Northwestern,  among  rail- 
roads; the  American  Telephone  and  Telegraph,  the  Pullman, 
the  United  Gas  Improvement,  among  large  public  utility  com- 
panies, enjoy  a  confidence  from  the  conservative  investing  class 
due  primarily  to  their  long  records  of  regular  dividends. 


XVI]  STOCKHOLDERS'  SURPLUS  175 

Besides  strengthening  the  investment  position  of  the  com- 
pany's stocks,  few  facts  help  the  sale  of  its  bonds  more  than 
the  statement  that  it  has  paid  regular  dividends  of  4  or  5  or 
6  per  cent  for  the  last  ten  or  twenty  or  thirty  years.  A 
dividend  record  showing  large  disbursements  during  years  of 
prosperity  and  passed  dividends  during  the  depressions,  stamps 
the  stock  as  speculative,  and  investors  tend  to  associate  the 
stock  and  the  bonds  together  in  one  category.  Few  instances 
show  this  more  clearly  than  the  case  of  the  American  Can 
Company,  the  stocks  of  which  had  deservedly  acquired  the 
reputation  of  being  a  mere  gamble.  When  the  bankers  sought 
to  sell  an  issue  of  bonds  of  the  company  to  the  investing 
public  they  found  themselves  confronted  by  the  evil  reputation 
of  the  company.  Its  abrupt  fluctuations  in  earnings,  reflecting 
themselves  in  an  uneven  dividend  rate,  coupled  with  certain 
notorious  stock  market  manipulations,  had  so  impressed  them- 
selves on  the  public  that  no  careful  investor  cared  to  associate 
his  money  with  the  enterprise,  no  matter  how  great  the  apparent 
security  of  the  bonds.  Another  case  in  point  is  that  of  the 
United  States  Rubber  Company.  During  the  year  19 14  the 
net  earnings  were  reported  to  be  over  $12,000,000.  The 
primary  security  was  the  collateral  trust  6  per  cent  bond  due 
in  1918.  At  first  glance  this  appeared  to  be  an  industrial  bond 
of  unquestioned  security,  with  interest  charges  earned  ten  times 
over.  Yet  it  sold  continuously  on  a  5^  to  6  per  cent  basis,  a 
much  higher  yield  than  other  quick-maturing  industrial  bonds 
of  equal  apparent  security.  The  8  per  cent  dividends  on  the 
first  preferred  stock  were  earned  nearly  twice  over,  and  the 
stock  sold  so  as  to  yield  the  investor  from  734  to  7%  per  cent. 
In  contrast,  the  United  States  Steel  Corporation  earned  its  bond 
interest  hardly  twice  over,  yet  the  corresponding  premier 
security  was  selling  to  yield  the  investor  less  than  5  per  cent. 
The  corporation  failed  by  nearly  $2,000,000  to  earn  the 
dividend  on  the  preferred  stock,  yet  the  stock  sold  throughout 


176  CORPORATION  FINANCE  [XVI 

the  year  so  as  to  yield  the  investor  from  6^  to  6j4  per  cent. 
The  primary  reason  for  this  anomaly  was  that  the  manage- 
ment of  the  United  States  Steel  Corporation  had  the  reputation 
of  being  open  and  straightforward  with  its  stockholders. 

Once  the  dividend  has  been  fixed  and  designated  as  a 
"regular"  dividend,  care  should  be  taken  that  it  be  fully  main- 
tained under  all  ordinary  circumstances.  For  this  reason  the 
management  should  use  care  that  a  proportion  of  the  book- 
keeping surplus  set  aside  during  years  of  liberal  net  profit 
should  be  invested  in  quick  assets  easily  converted  into  money 
for  the  payment  of  dividends  during  years  of  depression.  The 
American  Shipbuilding  Company  failed  to  observe  this  cardinal 
principle  and  felt  compelled  to  pass  its  preferred  dividend  the 
first  year  of  depression  in  spite  of  the  fact  that  there  had  been 
accumulated  a  bookkeeping  surplus  almost  equal  to  the  par  value 
of  the  preferred  stock.  It  had  been  entirely  sunk  in  long-term 
— many  of  them  unproductive — improvements  and  lost  to  the 
stockholders.  The  directors  faced  this  unpleasant  fact  and 
courageously  effaced  from  their  books  over  $3,500,000  of 
bookkeeping  surplus — over  half  the  apparent  surplus. 

Prediction  of  Earnings. — The  prediction  of  earnings  is 
not  quite  as  difficult  for  an  old-established  business  as  for  a 
comparatively  new  business.  Investors  in  New  England  public 
utilities  have  realized  this  during  the  last  decade.  Earlier  in 
the  chapters  dealing  specifically  with  new  enterprises,  various 
principles  were  suggested  that  enabled  promoter,  banker,  and 
investor  to  make  intelligent  guesses  concerning  the  future  earn- 
ings of  new  enterprises.  But  in  the  case  of  old-established 
companies  having  their  own  experience  to  guide  them,  there 
are  ample  data  available  to  make  the  dividend  policy  of  a  cor- 
poration, based  on  future  earnings,  something  more  than  a 
mere  intelligent  guess. 

Common  presumptions  and  "street  proverbs"  regarding  the 


XVI]  STOCKHOLDERS'  SURPLUS  177 

regularity  or  irregularity  of  corporate  earnings  cannot  always 
withstand  critical  analysis.  It  has  always  been  assumed,  for 
example,  that  public  utility  earnings  are  more  regular  than  the 
earnings  of  industrial  enterprises.  This  is  undoubtedly  true 
under  ordinary  circumstances,  but  it  is  also  undoubtedly  true 
that  the  earnings,  both  gross  and  net,  of  many  utilities  under- 
went more  abrupt  fluctuations  during  the  Great  War  than  the 
earnings  of  many  industrials.  The  latter  could  raise  their 
selling  prices  as  their  costs  advanced,  whereas  the  utilities, 
dependent  on  the  slow  routine  of  public  commission,  found 
themselves  ground  between  fixed  rates  and  rising  costs. 

In  general  it  will  be  observed  that  the  business  supplying 
a  commodity  which  is  sold  directly  to  and  immediately  used  by 
the  ultimate  consumer,  has  a  more  stable  earning  capacity  than 
a  business  which  produces  goods  to  be  used  by  other  businesses 
in  the  production  of  something  else.  For  example,  a  business 
which  produces  matches  and  sells  them  to  the  public  is  of  the 
first  type.  Its  goods  are  sold  directly  to  the  consuming  public. 
They  are  immediately  used  up.  No  consumer  acquires  more 
than  a  limited  supply  of  matches,  and  they  are  a  negligible  item 
in  his  total  expenditures.  The  consumer  does  not,  therefore, 
buy  matches  liberally  in  times  of  business  activity  when  he 
"feels  rich,"  nor  does  he  curtail  his  purchases  of  matches 
during  a  business  depression.  The  sales,  therefore,  of  a  match 
factory  are  independent  of  business  depressions.  True,  like 
all  manufacturing  businesses,  the  earnings  will  fluctuate  in 
accordance  with  variations  in  the  skill  of  management  and  the 
ordinary  hazards  of  any  business  enterprise.  This  is  admitted. 
But  if  there  is  a  relative  uniformity  in  the  skill  of  management, 
the  gross  sales  of  matches  and  the  resulting  net  profit  should  be 
relatively  constant. 

The  business  of  manufacturing  locomotives,  on  the  other 
hand,  meets  just  the  opposite  conditions.  A  locomotive  is  not 
used  up.     It  is  not  sold  to  the  ultimate  consumer,   for  the 


178  CORPORATION  FINANCE  [XVI 

ultimate  consumer  is  not  the  railroad,  but  the  railroad's  patron. 
The  locomotive  is  merely,  in  itself,  an  instrument  of  produc- 
tion. Unless  there  is  freight  to  be  moved  it  is  valueless.  Rail- 
roads will  use  their  old  locomotives  during  periods  when 
there  is  reduced  freight  movement;  they  will  rush  into  the 
market  to  purchase  locomotives  as  soon  as  an  industrial  boom 
increases  their  volume  of  freight  receipts  beyond  the  wonted 
capacity.  In  consequence  the  manufacturer  of  locomotives 
will  make  few  sales  during  the  period  of  business  depression 
and  the  earnings  of  his  business  will  be  small,  no  matter  how 
much  skill  of  management  he  may  exercise.  And,  conversely, 
the  sales  of  locomotives  during  periods  of  great  business 
activity  will  be  very  large,  and  the  earnings  will  be  exorbitant, 
irrespective,  almost,  of  the  business  skill  of  the  manufacturer. 

This  difference  in  the  relative  constancy  and  variability 
in  the  earnings  of  two  types  of  corporations  is  further  in- 
tensified by  differences  in  price  of  the  commodities  sold.  The 
lower  the  cost  the  more  stable  the  earnings;  the  higher  the 
cost,  the  greater  the  fluctuations  in  earnings.  Again  this 
principle  is  further  modified  by  the  relative  importance  of  the 
commodities  manufactured  and  sold.  Notwithstanding 
matches  and  sealing  wax  are  both  low-cost  commodities  sold 
to  and  directly  consumed  by  the  ultimate  consumer,  they  are 
not  equally  necessary;  notwithstanding  locomotives  and  auto- 
matic lathes  are  high-priced  commodities  sold  to  railroads  to 
be  used  in  producing  transportation  service,  they  are  not 
equally  necessary. 

From  these  observations  it  will  be  possible  to  formulate 
a  general  law  :  Earnings  of  corporations  engaged  in  the  pro- 
duction of  inexpensive  necessities,  sold  to  and  immediately 
consumed  by  the  ultimate  consumer,  are  most  regular  and  most 
subject  to  reliable  prediction;  earnings  of  corporations  engaged 
in  the  production  of  costly  commodities,  sold  to  other  producers 
and  not  absolutely  necessary  for  the  operation  of  their  biisi- 


XVI]  STOCKHOLDERS'  SURPLUS  179 

nesses,  are  least  regular  and  least  subject  to  reliable  prediction. 
These  are  the  extreme  cases.  Between  these  extremes  he  the 
majority  of  corporate  business,  and  the  relative  predictabiHty 
of  their  earnings  will  be  determined  according  as  they  tend 
toward  one  extreme  or  the  other. 

An  Empiric  Illustration  of  the  Law  of  Earnings. — This 
law  has  ample  justification  in  experience.  It  is  empirically 
illustrated  by  the  two  commodities  already  cited — matches 
and  locomotives.  For  the  purposes  of  illustration  it  is  fortu- 
nate that  these  two  commodities  are  manufactured  by  large 
corporations  whose  earnings  are  matters  of  public  record.  In 
the  whole  history  of  American  industrial  consolidations  it  is 
probably  impossible  to  find  the  earnings  of  a  single  large  busi- 
ness as  constant,  uniform,  and  "smooth"  as  those  of  the 
Diamond  Match  Company  during  a  period  of  sixteen  years. 
The  company  was  doing  millions  of  dollars  of  gross  business. 
Yet  in  1900  the  net  earnings  were  within  less  than  $100,000  of 
those  of  191 5.  The  panic  of  1907  had  absolutely  no  effect  on 
the  net  earnings,  and  the  "boom"  period  of  1905  to  1907  could 
not  be  detected  from  an  inspection  of  these  earnings.  Even 
large  public  utilities,  even  water  companies,  whose  earnings  are 
proverbially  constant,  can  hardly  show  a  record  of  regularity 
and  stability  of  earnings  equal  to  this. 

In  contrast  to  the  regularity  of  these  earnings  are  those  of 
the  American  Locomotive  Company,  covering  essentially  the 
same  period,  except  that  the  last  three  years  of  the  Great  War 
are  included.  (The  company  was  organized  in  1901.)  Its  net 
earnings  dropped  from  $5,000,000  before  the  panic  of  1907 
to  $1,000,000  immediately  afterward;  it  endured  an  actual 
manufacturing  loss  of  $1,000,000  in  the  first  year  of  the  Great 
War  and  then  a  net  profit  of  $11,000,000  the  year  following. 
The  extreme  fluctuation  in  the  net  earnings  of  the  American 
Locomotive  Company  in  itself  in  nowise  affects  the  policy  of 


l8o  CORPORATION  FINANCE  I XVI 

paying  regular  and  dependable  dividends.  This  company  has 
paid  the  7  per  cent  dividend  on  its  preferred  stock  every  year 
since  it  was  organized  in  1901.  In  two  of  the  years,  1909  and 
191 5,  the  preferred  stock  dividend  was  not  earned.  It  was 
paid  nevertheless.  And  this  course  was  eminently  wise,  because 
the  reserves  accumulated  during  years  of  large  earnings  were 
ample  to  safeguard  the  general  credit  of  the  company. 

Extra  Dividends. — If  a  conservative  policy  of  regular 
dividends  is  followed,  it  is  reasonable  to  expect  that  more 
money  will  accumulate  in  the  undistributed  profits  account  than 
the  usages  of  the  business  warrant.  Under  such  circumstances 
the  directors  may  feel  warranted  in  declaring  an  additional 
distribution  in  excess  of  the  regular  dividend.  This  should 
be  called  an  "extra  dividend"  to  indicate  to  the  stockholders 
that  the  interest  is  not  regarded  by  the  directors  as  permanent. 
Some  corporations  have  gone  so  far  as  to  have  a  separate 
check  made  out  for  the  extra  dividend,  so  that  under  no  cir- 
cumstances will  the  stockholder  confuse  the  additional  payment 
with  the  regular  payment,  and  especial  care  should  be  exercised 
by  the  directors  that  the  extra  dividend  is  not  made  the  occasion 
of  stock  manipulation  or  misrepresentation. 

Bond  and  Scrip  Dividends. — In  the  few  cases  in  which  it 
seems  advisable  to  declare  a  dividend,  although  the  money  can- 
not be  readily  withdrawn  from  the  business,  it  is  customary 
to  pay  the  dividend  in  some  form  of  security.  This  may  be 
cither  bonds,  scrip,  or  stock.  A  bond  dividend  is  rarely  used. 
"A  scrip  dividend,"  as  one  writer  aptly  puts  it,  "divides  the 
profits  but  defers  the  actual  distribution  of  the  assets."  The 
most  plausible  excuse  for  the  issue  of  scrip  dividends  is  that, 
owing  to  general  business  uncertainty,  the  corporation  prefers 
to  hold  the  money  in  its  treasury  rather  than  to  distribute  it 
among  its  stockholders.    But  there  are  numerous  cases,  especi- 


XVI]  STOCKHOLDERS'  SURPLUS  l8l 

ally  among  public  service  holding  companies,  in  which  this  scrip 
dividend  is  a  mere  device  for  postponing  the  unpleasant  con- 
fession that  the  company  is  without  sufficient  resources  to  pay 
any  dividends  at  all.  By  questionable  methods  of  accounting 
which  neglect  adequate  depreciation  and  other  reserves,  it  may 
be  made  to  appear  that  the  business  of  the  year  has  yielded  a 
net  profit.  The  management  then  points  out  that  the  demands 
of  the  business  were  such  that  the  year's  profit  was  absorbed 
by  the  heavy  new  construction  which  increased  the  value  of 
the  property  assets.  On  the  basis  of  this  apparent  increase  in 
the  property  account,  the  management  purports  to  feel  justi- 
fied in  incurring  a  new  liability  in  the  form  of  the  scrip  divi- 
dend. The  process  may  be  repeated  year  after  year,  and  as  no 
real  money  is  paid  out  in  dividends,  the  actual  operation  of 
the  company  is  not  hampered.  Ultimately  the  deceit  will  be 
discovered  through  the  uncovering  of  the  fictitious  figures  at 
which  the  property  account  is  carried,  but  in  the  meantime  the 
managers  will  have  been  able  to  maintain  the  stock  at  a  market 
price  higher  than  if  no  dividends  whatever  had  been  paid. 

Stock  Dividends. — The  commonest  and  most  important 
of  security  dividends  are  stock  dividends.  These  as  a  class  owe 
their  origin  to  financial  success.  Scrip  dividends  quite  generally 
are  substitutes  for  cash  dividends  and  therefore  an  outward 
sign  of  at  least  temporary  weakness.  But  this,  except  in  rare 
cases,  is  not  true  of  stock  dividends,  although  a  desire  to  effect 
a  speculative  and  unjustifiable  enhancement  in  market  price  is 
often  the  dominating  motive  in  leading  directors  to  declare 
stock  dividends.  In  other  cases  the  wisdom  of  declaring  stock 
dividends  is  very  much  open  to  question,  notwithstanding  the 
fact  that  such  dividends  may  be  fully  justified  by  the  books 
of  account  of  the  corporation.  And  in  general  we  may  lay 
down  two  guiding  principles,  one  of  accounting  and  the  other 
of  general  business  expediency,  which  should  control  the  decla- 


I82  CORPORATION  FINANCE  [XVI 

ration  of  stock  dividends.  Both  of  these  are  of  considerable 
importance. 

The  bookkeeping  procedure  in  connection  with  the  declara- 
tion of  a  stock  dividend  should  consist  merely  of  a  transfer 
of  an  amount  sufficient  to  cover  the  new  issue  of  stock,  from 
the  surplus  account — accumulated  through  annual  profits — to 
the  capital  stock  account.  If  this  principle  is  carefully  ob- 
served and  it  is  borne  in  mind  that  theoretically  as  well  as 
legally  no  stock  should  be  issued  unless  it  represents  property 
equivalent  to  the  full  par  value  of  the  stock,  it  follows  that 
stock  dividends  should  never  be  tolerated  unless  the  actual 
earnings  to  a  considerable  amount  are  employed  by  the  manage- 
ment :  ( I )  to  construct  new  buildings  and  equipment,  or  (2)  to 
increase  the  net  quick  assets  in  order  to  maintain  or  strengthen 
the  general  credit  position  of  the  company.  Whether  or  not 
earnings  shall  be  reinvested  in  property  or  paid  out  in  divi- 
dends is  merely  a  matter  of  business  judgment.  But  that  there 
must  be  actual  earnings  to  do  either,  is  fundamentally  a  matter 
of  simple  business  honesty,  to  be  expressed  outwardly  in  the 
accounts.  It  is  not  a  matter  of  judgment  or  expediency  or 
anything  of  the  kind,  but  of  truth. 

The  other  principle  to  be  observed  is  that  the  stock  dividend 
should  not  be  declared,  even  when  the  invested  profit  and  loss 
surplus  is  ample,  if  the  credit  position  is  not  fundamentally 
sound.  Although  a  stock  dividend  may  not  deplete  the  quick 
assets  as  a  cash  dividend  does,  it  is  an  outward  sign  of  an  excess 
of  capital  in  the  business  not  in  the  least  consistent  with 
outside  borrowings.  If  loans  are  floated  at  the  same  time 
that  a  stock  dividend  is  issued,  the  latter  is  a  false  indication 
of  financial  strength. 

Taxation  of  Stock  Dividends. — The  whole  subject  of  stock 
dividends  has  assumed  a  new  importance  of  late  in  connection 
with  the  income  taxes  of  the  federal  government  and  several  of 


XVI]  STOCKHOLDERS'  SURPLUS  1 83 

the  States.  Each  of  the  income  revenue  laws  attempts  to  tax 
income  wherever  and  however  it  occurs,  with  the  exception  of 
certain  specific  exemptions.  Stock  dividends  are  not  specifi- 
cally exempted,  so  that  both  the  federal  and  state  income  tax 
commissioners  have  tried  to  tax  stock  and  security  dividends. 
This  has  been  done  under  the  Massachusetts  state  income  tax 
without  serious  objection  from  the  courts,  but  the  Supreme 
Court  of  the  United  States  decided  in  two  very  important  cases 
that  stock  dividends  were  not  income.  As  a  result  much  dis- 
cussion has  arisen,  bearing  partly  on  the  economics  of  the 
distinction  between  capital  and  income  and  partly  on  the  ex- 
pediency and  efficacy  of  trying  to  tax  stock  dividends. 

Property  Dividends. — Another  type  of  security  dividend 
of  considerable  prominence  since  the  rarge  issues  of  Liberty 
bonds  is  that  involving  a  distribution  of  securities  held  in  a 
company's  treasury.  During  the  Great  War  many  successful 
industrial  corporations  made  large  subscriptions  to  government 
bonds.  At  the  same  time  they  obtained  extraordinary  war 
profits.  A  considerable  proportion  of  these  war  profits  were 
paid  over  to  the  United  States  Treasury  in  the  form  of  war 
taxes,  but  the  remainder  was  still  abnormally  large.  Yet  in- 
stead of  depleting  their  cash  reserves  or  selling  their  Liberty 
bonds  to  secure  working  capital,  these  corporations  paid  special 
dividends  in  the  Liberty  bonds  held  in  their  treasuries. 

In  1 91 9  the  United  States  government  forced  the  packing 
house  of  Swift  and  Company  to  get  rid  of  certain  of  its  sub- 
sidiary companies  engaged  in  food  businesses  allied  to  the  pack- 
ing business.  The  stock  of  these  subsidiaries  were  distributed 
among  the  stockholders  of  Swift  and  Company. 

The  United  Shoe  Machinery  Company  acquired  the  stock 
of  the  Thomas  G.  Plant  Company.  The  Plant  Company  was 
engaged  in  the  manufacture  of  shoes — not  shoe  machinery — 
but  its  owner  had  threatened  to  enter  the  machinery  line  of 


1 84  CORPORATION  FINANCE  [XVI 

business.  The  purchase  of  the  company's  stock  involved,  there- 
fore, merely  buying  out  potential  competition,  but  at  the  same 
time  the  Shoe  Machinery  Company  found  itself  with  the  stock 
of  a  shoe  factory  on  its  hands.  Accordingly  it  distributed  the 
Plant  Company's  stock  in  the  form  of  a  stock  dividend  of  $6, 
par  value,  a  share  to  its  own  stockholders,  payable  July,  191 6. 

Summary  of  Sound  Dividend  Policy. — In  closing  this  dis- 
cussion no  more  comprehensive  summary  of  sound  dividend 
policy  can  be  found  in  the  whole  annals  of  American  financial 
history  than  a  certain  resolution  of  the  Board  of  Directors  of 
the  Union  Pacific  Railroad.  An  entirely  new  and  very  able 
management  acquired  control  of  the  road  at  the  time  of  its 
reorganization  in  1897.  During  the  succeeding  two  years 
large  sums  of  money  were  expended  in  betterments.  Control 
of  connecting  roads  was  acquired  at  low  prices  and  through  able 
management  enormous  equities  were  built  up  for  the  benefit 
of  the  Union  Pacific  Railroad.  And  the  gross  and  the  net 
earnings  had  increased  by  leaps  and  bounds  so  that  the  general 
credit  of  the  road  was  becoming  firmly  established  notwith- 
standing its  previous  unfortunate  history.  Yet  the  directors, 
on  the  crest  of  this  initial  prosperity,  refused  to  pay  the  full 
dividend  on  the  preferred  stock  and  passed  a  resolution  which 
began  as  follows : 

Whereas  the  company  has  been  in  possession  of  all  its  main 
lines  barely  a  year,  and  of  its  branch  lines  a  less  time,  and  is 
therefore  without  a  basis  of  experience  for  determining  any 
fair  average  of  results  for  unequal  years,  and  it  is  not  deemed 
advisable  to  add  to  the  bonded  debt,  but  to  continue  a  liberal 
application  of  surplus  income  to  permanent  improvements 
and  additions  and  to  such  uses  as  will  secure  economy  of 
operation  and  increased  earning  power,  and  thereby  establish 
stable  and  permanent  values  for  its  securities  and  a 
reasonably  safe  minimum  basis  of  regular  dividends  to  its 
stock. 


XVI]  STOCKHOLDERS'  SURPLUS  1 85 

This  is  sound  finance.  And  the  marvelous  success  of  the 
Union  Pacific  Railroad  during  the  following  decade  is  the 
strongest  kind  of  empirical  proof  of  the  wisdom  contained  in 
this  resolution. 


CHAPTER  XVII 

BUSINESS  EXPANSION  AND  THE  LAW  OF 
BALANCED  RETURNS 

Ultimate  Success  or  Failure. — A  business  corporation  is 
either  a  success  or  a  failure.  Although  a  business  may  main- 
tain for  a  considerable  time  a  quiet  existence  showing  no  out- 
ward change,  yet  in  the  long  run  an  observer  will  see  clearly 
that  it  has  gone  either  forward  or  backward.  Many  corpora- 
tions go  down-hill  very  rapidly  and  become  failures  within  a 
few  months  after  their  promotion;  with  others  the  causes  of 
disaster  take  longer  to  operate  and  may  not  precipitate  failure 
for  several  years.  The  failure  of  the  old  United  States  Ship- 
building Company,  now  the  Bethlehem  Steel  Corporation, 
followed  so  quickly  after  its  promotion  that  it  is  difficult  to  say 
that  the  company  had  any  real  existence  of  its  own,  whereas, 
the  causes  behind  the  failure  of  the  International  Steam  Pump 
Company  in  1914  were  present  from  the  organization  of  the 
company  in  1899,  yet  by  the  aid  of  temporary  loans  and  less 
obvious  palliatives  they  were  obscured  from  the  outside  until 
the  autumn  of  191 3.  The  same  thing  is  true  of  the  success 
of  a  corporation.  In  fact,  as  the  first  few  years  are  devoted 
to  organization  and  to  establishing  a  place  in  the  trade,  pro- 
nounced success  is  not  likely  to  show  itself  so  early  as  pro- 
nounced failure.  Yet  in  the  long  run  it  is  just  as  evident  as 
failure,  although  the  consequences  may  not,  perhaps,  be  so 
dramatic. 

The  remarkable  but  sporadic  success  which  certain  manu- 
facturing companies  obtained  through  foreign  orders  for 
munitions  soon  after  the  outbreak  of  the  Great  War  is  not  an 
exception  to  this  rule.     The  success  in  most  cases  was  only 

186 


XVII]  THE  LAW  OF  BALANCED  RETURNS  187 

apparent,  not  real,  and  vanished  even  before  the  contracts  were 
executed.  The  vast  majority  of  those  corporations  which 
profited  greatly  by  the  war  were  already  successful  or  else  had 
developed  a  highly  efficient  productive  organization  before 
the  war. 

Personal  Motives  Leading  to  Expansion. — If  the  corpora- 
tion is  a  success  the  directors  are  prompted  to  think  of  increas- 
ing the  capacity  of  the  business.  They  will  urge  the  likelihood 
of  increased  profits  as  the  reason  for  doing  this;  but  behind 
such  a  reason  will  be  others.  The  impelling  springs  of  human 
actions  are  difficult  to  fathom.  Business  managers  are  human 
beings.  Their  solutions  of  the  difficult  problems  of  business 
expansion  are  not  always  determined  solely  by  economic 
expediency. 

I.  Ambition. — The  most  powerful  motive  in  leading  to  a 
desire  to  expand  a  business  is  the  illusion  of  valuing  oneself 
n  terms  of  one's  setting.  The  bigger  the  business  the  bigger  the 
man.  This  motive  is  much  more  fundamental  than  is  usually 
realized.  A  man  who  operates  successfully  a  corner  drug 
store  may  be  content  with  the  business  as  it  is,  provided  he 
finds  the  field  of  his  primary  interests  outside  of  his  business — 
home,  sport,  or  an  avocation.  In  such  a  case,  which  is  com- 
mon, the  business  is  an  insignificant  means  to  an  end.  It  is 
not  a  part  of  the  real  life  of  the  man,  but  merely  an  attendant 
circumstance  in  the  problem  of  extracting  a  livelihood  out  of 
a  competitive  and  unsentimental  world.  But  such  men  are  not 
true  business  managers  in  the  sense  that  the  economist  uses 
the  word  "manager"  or  "entrepreneur."  Their  field  of  achieve- 
ment is  not  business  success.  Men  who  can  be  classified 
as  business  managers  and  who  value  success  in  productive 
enterprise  as  something  worth  while  in  itself — rather  than  as 
an  insignificant  means  to  a  greater  end — want  their  business 


l88  CORPORATION  FINANCE  [XVII 

undertaking  to  bear  the  outward  signs  of  successful  achieve- 
ment. Increasing  size  is  the  most  obvious  of  these  signs.  The 
race-old  instinct  of  conquest  becomes  translated  in  our  twen- 
tieth century  economic  world  into  the  prosaic  terms  of  corpor- 
ate growth.  Business  expansion  is  the  spirit  of  a  modern 
Tamerlane  seeking  new  markets  to  conquer.  Business  is  a 
pawn  for  human  ambition. 

2.  The  Creative  Impulse. — A  second  motive,  less  signifi- 
cant, one  is  led  to  believe,  is  the  creative  impulse.  A  business 
manager  has  an  aversion  to  stagnation;  he  wishes  to  be  con- 
structive. He  wishes  to  make  actual  the  vague  images  of 
progress.  The  only  field  with  which  he  is  familiar  is  his  busi- 
ness, and  in  the  fortunes  of  his  business  he  sees  the  realization 
of  his  ideals.  It  is  a  commonplace  of  psychology,  current  since 
the  brilliant  introspective  studies  of  the  elder  Mill  and  Reid, 
that  somewhere  in  the  mental  structure  of  all  of  us  lies  the 
impulse  to  build,  to  see  our  ideas  take  form  in  material  results. 
The  impulse  to  build  is  at  the  same  time  an  important  element 
in  inventive  and  artistic  genius  and  in  skilful  craftsmanship. 
The  particular  form  in  which  it  finds  expression  is,  among 
men  of  ordinary  ability,  certainly  a  matter  of  accident.  And 
the  particular  form  close  at  hand  to  the  business  manager  is 
his  business.  A  distinguished  business  manager,  at  sixty-nine 
years  of  age,  to  whom  wealth  had  ceased  to  have  a  significance, 
was  heard  to  outline  in  detail  for  an  already  well-rounded  and 
worldwide  business,  steps  in  reconstruction  and  enlargement 
which  would  ordinarily  take  a  lifetime  to  achieve.  An  expand- 
ing business  afifords  a  sphere  for  the  kind  of  creative  expression 
demanded  by  our  twentieth  century  industrialism. 

3.  Desire  to  Speculate. — A  third  motive  is  the  satisfaction 
in  taking  speculative  chances.  Business  managers  like  to  deal 
with  a  future  full  of  concrete  uncertainties.    They  like  to  apply 


XVII]  THE  LAW  OF  BALANCED  RETURNS  1 89 

direct  empirical  tests  to  business  policies  the  results  of  which  are 
at  best  uncertain.  The  development  of  constructive  plans  par- 
takes of  the  nature  of  a  game,  and  all  men  enjoy  the  game  they 
think  they  can  play. 

Application  of   Diminishing   Returns  to   Manufacturing. 

— Brushing  aside  the  non-humanistic  aspects  of  business  ex- 
pansion the  question  ultimately  narrows  itself  down  to  one  of 
economic  sanctions.  Expansion  will  bring  disaster  unless  the 
conditions  of  the  industry  and  the  particular  business  are  such 
that  the  big  business  is  at  least  relatively  as  profitable  as  the 
small  business.     This  is  not  necessarily  so. 

It  does  not  always  pay  to  expand.  In  fact  there  is  probably 
no  other  one  policy  which  brings  disaster  to  the  old-established 
business  more  often  than  the  putting  into  practice  of  the 
fallacious  principle  that  profits  necessarily  expand  as  the  busi- 
ness expands.  Students  of  economic  theory  have  restricted  the 
application  of  the  law  of  diminishing  returns  to  agriculture 
and  the  extractive  industries.  And  it  must  be  admitted  that 
the  law,  if  such  a  name  can  be  applied  to  a  principle  so  vague 
and  inexact,  is  best  illustrated,  empirically,  by  examples  taken 
from  these  fields  of  industry.  This  is  evident.  It  requires  no 
wide  knowledge  of  agriculture  to  observe  that  to  double  the 
labor  or  to  double  the  fertilizer  does  not  necessarily  mean  a 
double  crop  of  potatoes  or  wheat  or  mushrooms. 

Lately,  especially  within  the  last  ten  or  fifteen  years,  econo- 
mists have  noted,  however,  that  the  economies  of  large-scale 
production,  particularly  when  spread  over  many  widely  sep- 
arated plants,  have  not  been  realized  to  anything  like  the  extent 
that  was  anticipated.  In  some  notorious  instances  they  were 
not  realized  at  all ;  the  product  was  so  much  smaller  relatively  in 
the  large-scale  than  in  the  small-scale  production,  that  the  entire 
business  resulted  in  a  financial  loss.  This  suggests  that  the  law 
of  diminishing  returns,  heretofore  applied  to  those  kinds  of 


190  CORPORATION  FINANCE  [XVU 

production  in  which  a  natural  resource  is  the  constant  factor 
and  labor  and  capital  the  variables  (like  agriculture  and  min- 
ing), can  be  applied  to  manufacture  if  only  varying  quantities 
of  the  factors  of  production,  capital  and  labor,  can  be  empiri- 
cally studied  in  their  effects  on  the  quantity  of  production. 

Constant    Labor    Costs    and    Varying    Capital    Costs • 

The  shoe  industry  affords  numerous  illustrations  of  varying 
costs  of  fixed  capital  under  a  constant  of  labor  costs.  The 
following  case  is  nighly  instructive.  A  certain  man  had  had 
long  training  in  the  business.  He  had  accumulated  enough 
money  to  operate  a  small  factory  with  rather  antiquated  and 
inefficient  equipment.  In  this  he  was  highly  successful. 
Spurred  on  by  his  success  he  built  a  modern  factory  to  manu- 
facture the  same  grade  of  shoes.  Indeed,  so  complete  and 
perfect  of  its  kind  was  the  new  factory  that  it  was  distinctly 
a  "show  establishment"  among  those  making  that  particular 
grade  of  shoe.  The  output  or  quantity  of  product  was  very 
much  greater  than  in  the  previous  factory,  although  the  same 
scale  of  piece-work  wages  prevailed.  He  failed,  losing  in  a 
short  space  of  time  practically  all  that  he  had  made  under 
the  previous  conditions.  He  exercised  the  same  entrepreneur 
ability  in  both  factories.  The  labor  costs  per  unit  of  product 
remained  as  constant  as  a  set  of  actual  conditions  would 
permit.  The  fixed  capital  costs  only  varied.  But  in  the  second 
case  they  were  so  much  greater  proportionally  to  the  cost  of 
labor  that  the  total  cost  of  the  product  exceeded  the  com- 
petitive price  value  determined  by  other  smaller  and  technically 
less  efficient  factories.  In  brief,  the  fixed  capital  cost  was 
too  great  for  that  particular  line  of  product. 

And  the  manufacturers  of  the  different  grades  of  shoes 
illustrate  varying  quantities  of  products  produced  under  condi- 
tions of  varying  quantities  of  capital  investment.  The  highest 
grades  of  shoes  are  "fine  turns,"  ladies'  wooden  heel  "fancies." 


XVII  ]  THE  LAW  OF  BALANCED  RETURNS  IQI 

and  gentlemen's  fine  custom  lasts.  These  industries  are  con- 
fined to  the  small  personally  superintended  shops  of  Haverhill, 
Brooklyn,  and  Newark.  They  are  the  nearest  approach  to 
the  old-fashioned  custom  shops  where  a  few  dollars'  worth 
of  tools  was  all  the  shoemaker  required  At  the  other  extreme 
are  the  large  capitalistic  establishments  of  Brockton,  Man- 
chester, and  St.  Louis,  manufacturing  the  cheapest  kind  of 
shoes  in  immense  quantities.  These  companies  had  introduced 
very  many  economies  of  large-scale  production,  but  at  enor- 
mous cost  of  equipment.  It  would  be  as  impossible  for  a 
Newark  shop  to  make  low-grade  men's  shoes  economically  as 
it  would  for  a  factory  devoted  to  cheap  shoes  to  turn  out  a 
Newark  shoe.  Each  is  successful  in  its  own  line  because  it  has 
solved  the  problem  of  the  balance  between  the  labor  cost  and 
the  fixed  capital  cost.  But  the  balance  is  determined  by  the  size 
of  the  output,  or  rather  by  the  quantity  of  product  most 
economically  produced.  Should  the  Newark  shop  introduce 
the  large-scale  efficiency  methods  in  the  endeavor  to  increase 
the  quantity  of  its  product  it  would  turn  out  so  many  "seconds" 
as  to  ruin  first  its  reputation  and  then  itself.  Should  the 
large-scale  factory  try  to  reduce  its  fixed  capital  expenditure 
by  substituting  more  labor  for  costly  equipment,  either  its 
labor  costs  would  rise  higher  in  proportion — thereby  increas- 
ing the  cost  of  its  product — or  else  the  quantity  of  its  product 
would  be  reduced — thereby  increasing  the  pro  rata  costs  of 
the  fixed  capital  and  overhead  and  therefore  the  costs  of 
the  product.  In  other  words,  the  Haverhill,  Brooklyn,  and 
Newark  manufacturers  (at  least  those  who  are  permanently 
successful)  have  discovered  that  nice  and  delicate  balance  be- 
tween the  ratio  of  labor  and  capital  costs  on  the  one  hand 
and  the  quantity  of  their  output  on  the  other.  They  have 
discovered  that  with  small  capital  costs  proportional  to  the 
total  value  of  the  product  they  must  adopt  small-scale  produc- 
tion.   And  the  great  highly  organized  factories  manufacturing 


192  CORPORATION  FINANCE  [XVII 

cheap  shoes  have  also  discovered  their  own  proper  balance — 
that  with  a  large  proportion  of  fixed  capital  costs  in  the  total 
cost  of  the  shoe  they  can  adopt  large-scale  production.  The 
manufacturer  described  in  the  preceding  paragraph,  who  was 
successful  with  a  small  cheaply  equipped  inefficient  shop  but 
unsuccessful  with  a  large  expensively  and  efficiently  con- 
structed shop,  had  not  discovered  the  proper  balance  for  his 
particular  grade  of  product — the  proper  scale  of  production 
for  the  most  economical  ratio  of  capital  and  labor  required 
by  his  particular  grade  of  shoe — therefore  he  failed. 

Constant  Capital  Costs  and  Varying  Labor  Costs. — 
Turn  now  to  the  other  set  of  observations,  dealing  with  cases 
where  the  costs  of  capital  remain  constant  but  the  quantity 
or  cost  of  labor  varies.  A  highly  instructive  series  of  such 
cases  is  afforded  by  those  metal  and  munition  manufacturers 
who  accepted  large-scale  orders  from  belligerent  governments 
at  the  outbreak  of  the  Great  War.  The  American  manu- 
facturers, especially  in  the  metal  industries,  were  lured  into 
taking  foreign  government  orders  by  high  prices  and  the 
expectation  of  liberal  profits.  They  were  forced  to  use  their 
existing  plants,  although  in  some  cases  additions  were  hurried 
forward  even  by  searchlight.  Increases  in  equipment  were 
not,  however,  important  in  the  first  hectic  rush ;  so  that  we  are 
dealing  with  a  rather  unusual  condition  of  a  constant  quantity 
of  fixed  capital  yielding  a  product  under  markedly  varying 
quantities  of  labor.  In  many  cases  the  labor  was  doubled, 
in  some  cases  even  trebled,  changing  from  one  lo-hour  shift 
to  three  8-hour  shifts.  Labor  was  increased  intensively.  More 
helpers  were  assigned  to  each  master;  there  was  greater 
division  of  labor  and  elimination  of  special  work.  The  results 
were  a  disappointment  to  the  managers.  The  product  was 
not  increased  proportionally.  Three  shifts  did  not  produce 
2.4  times  as  much  as  a  single   lo-hour  shift;  the  increased 


XVII]  THE  LAW  OF  BALANCED  RETURNS  193 

intensification  of  labor  within  the  shop  did  not  make  a  cor- 
responding increase  in  the  quantity  of  the  product. 

If  the  matter  were  allowed  to  remain  there,  the  failure 
of  our  manufacturers  to  meet  the  sudden  and  very  unusual 
demands  put  upon  them  by  the  war  would  be  attributed  tc 
the  role  of  the  law  of  diminishing  returns  in  modern  industry. 
But  the  experiences  of  the  munition  and  metal  manufacturers 
were  various.  In  some  cases,  as  with  the  manufacturers  of 
timing  devices  for  shrapnel  shells  and  of  other  materials 
requiring  fine  handwork,  the  disaster  which  befell  the  con- 
tractors was  worse  than  that  of  other  larger  establishments 
taking  contracts  for  the  kind  of  war  material  that  could  be 
turned  out  largely  by  machinery.  The  little  Connecticut  or 
Vermont  shop  that  undertook  the  handwork  subcontract  was 
ruined,  whereas  the  Bethlehem  Steel  Corporation,  the  West- 
inghouse  Electric,  and  Remington  companies  merely  made  less 
money  than  was  anticipated.  The  handwork  shops  attempted 
large-scale  production  by  merely  increasing  the  quantity  of 
labor,  and  disaster  overcame  them  immediately.  The  estab- 
lishments already  committed  to  the  manufacture  of  products 
in  which  the  cost  is  largely  one  of  fixed  capital,  plants  already 
large-scale  in  comparison  with  the  others,  were  able  to  increase 
yet  further  their  scale  of  operations  without  serious  loss.  And 
it  is  notable  that  the  particular  steel  company  which  suflfered 
at  the  beginning  the  largest  relative  curtailment  of  anticipated 
profits,  the  Crucible  Steel  Company,  has,  more  than  any  other 
of  the  large  steel  companies,  a  considerable  labor  element  in 
the  cost  of  its  product 

The  Law  of  Balanced  Return. — It  appears  that  when  the 
quantity  of  labor  to  be  applied  to  a  given  constant  of  fixed 
capital  is  varied,  different  types  of  industry  respond  differently 
to  the  changes.  If  the  industry  manufactures  a  product  in 
which  the  labor  element  is  large,  the  quantity  of  that  product 


194  CORPORATION  FINANCE  [XVII 

cannot  be  increased  by  increasing  the  quantity  of  labor,  except 
at  a  very  large  increase  in  the  cost  of  production.  If,  on  the 
other  hand,  the  product  is  one  in  which  fixed  capital  is  far  and 
above  the  larger  element  in  the  final  cost,  then  a  sudden  increase 
in  the  quantity  of  labor  working  upon  the  capital  invested  will 
not  so  seriously  affect  the  cost  of  the  product.  The  practical 
business  man,  with  what  he  calls  "horse  sense,"  discriminates 
among  manufacturing  businesses  according  to  differences  in 
the  quantity  of  labor  that  goes  to  make  up  the  product.  He 
says,  "If  you  have  little  capital,  go  into  a  business  with  a  good 
deal  of  handwork."  This  is  another  way  of  saying  that  suf- 
ficient special  economies  to  enable  the  producer  to  sell  in  a  free 
competitive  market  can  be  attained  in  a  small-sized  shop  if  labor 
predominates  in  the  cost  of  production,  whereas  if  the  labor 
costs  are  relatively  small  only  the  shop  capable  of  manufactur- 
ing large  quantities  of  the  product  can  survive. 

Such  comparison  as  this  drawn  from  various  industries 
lead  to  the  conclusion  that  there  is  a  point  of  maximum  pro- 
ductivity as  the  quantity  of  labor  and  of  capital  is  increased, 
but  that  this  point  varies  in  position  according  to  the  relative 
proportions  of  capital  and  labor  represented  in  the  final  product. 
If  the  product  is  fine  shoes,  representing  a  large  ratio  of  labor 
to  invested  capital,  the  point  is  reached  in  a  relatively  small 
scale  of  production;  if  it  is  inexpensive  low-grade  men's  shoes, 
it  is  reached  only  under  conditions  of  very  large-scale  produc- 
tion. This  connection  between  the  capital  and  labor  involved 
may  be  stated  in  the  following  form,  a  general  principle  ap- 
proaching the  rigor  of  a  law  as  near  as  the  flexibility  of 
economic  phenomena  permits.  It  is  this :  The  ratio  between  the 
quantitative  values  of  labor  and  fixed  capital  in  any  unit  or 
product  determines  the  point  at  which  increase  in  the  scale 
of  total  production  ceases  to  be  economical;  i.e.,  it  determines 
the  point  of  maximum  productivity  beyond  which  further  in- 
vestments of  fixed  capital  and  further  increments  of  labor  cease 


XVII  ]  THE  LAW  OF  BALANCED  RETURNS  1 95 

to  yield   the  same  proportionate  quality   of  product.     This 
may  be  called  the  "law  of  balanced  return." 

Illustration  of  the  Operation  of  the  Law — i.  In  the  Steel 
Industry. — Numerous  instances  having  to  do  with  large-  and 
small-scale  production  justify  this  principle  in  our  actual 
experience.  The  most  significant  revelation  of  the  history 
of  industrial  consolidation  that  followed  the  depression  of 
the  middle  nineties  was  that  the  anticipated  economies  of  large- 
scale  production  were  not  forthcoming.  In  certain  industries, 
such  as  the  steel  industry,  the  divergence  between  theory  and 
practice  was  not  as  marked  as  in  others.  But  nevertheless, 
in  spite  of  exceptions,  the  fact  remains  that  the  industrial  con- 
solidations based  on  the  fundamental  presumption  of  the 
economies  of  large-scale  production  were  a  profound  disap- 
pointment to  the  student  of  economics  and  the  practical  busi- 
ness man  alike. 

In  those  types  of  industry  where  the  human  element  is 
of  small  importance  in  the  final  product  an  increase  in  the 
quantity  of  labor  applicable  to  capital  could  be  made  to 
keep  pace  with  an  increase  in  the  capital  even  up  to  a  point 
of  an  extremely  large  scale  of  production.  This  is  now  true 
of  the  steel  industry.  The  fixed  capital  has  become  enormously 
large,  but  less  and  less  does  labor  play  a  part  in  the  final 
product.  The  very  purpose  behind  the  increase  in  fixed  capital 
has  been  the  substitution  of  mechanistic  production  for  human. 
And  as  the  ratio  between  the  quantity  of  capital  applicable  to 
each  unit  of  labor  has  increased,  the  scale  upon  which  produc- 
tion can  occur  economically  has  increased  correspondingly.  In 
fact,  so  far  has  the  successful  substitution  of  machinery  for 
labor  been  carried  in  the  steel  business  that  it  affords  to  the 
minds  of  many  students  the  best  example  in  modern  industry 
of  economical  large-scale  production.  It  has  been  reported 
by  four  entrepreneur  steelmakers  of  wide  experience  and  acute 


196  CORPORATION  FINANCE  [XVII 

understanding,  that  no  thoroughly  economical  establishment 
for  the  manufacture  of  steel  and  its  simpler  products  can  be 
built  short  of  $10,000,000.  Coupled  with  this  large  scale  of 
production  is  the  fact  that  in  the  value  of  the  final  product 
the  pro  rata  share  of  the  fixed  capital  is  enormous,  while  the 
direct  labor  costs  are  exceedingly  small.  That  the  labor  costs 
are  proportionately  the  smallest  of  any  industry  would  be 
difficult  to  prove,  but  it  is  a  matter  of  personal  judgment  that 
this  is  true.  It  explains,  as  nothing  else  can,  why  the  American 
steelmakers,  paying  higher  nominal  wages  than  in  any  other 
steel  industry  of  the  world,  can  undersell  their  foreign  com- 
petitors in  neutral  markets.  Although  the  total  wage  received 
by  each  man  is  very  high,  the  labor  costs  per  ton  of  fabricated 
steel  are  very  low,  due  to  the  extended  use  of  machinery. 

2.  In  the  Cotton  Industry. — The  cotton  manufacturing  in- 
dustry is  one  of  the  oldest  in  the  United  States.  By  the  close 
of  the  nineteenth  century  there  were  a  great  many  cotton  mills 
scattered  over  the  eastern  states.  They  were  particularly  numer- 
ous in  certain  regions  of  New  England,  the  vicinity  of  Balti- 
more, and  in  parts  of  the  South.  This  concentration  of  many 
small  units  in  certain  localities  was  a  circumstance  which  in 
many  industries  promoted  the  combination  of  small  competitors 
into  large  industrial  combinations.  But  in  the  cotton  industry 
only  three  combinations  were  attempted,  and  all  three  of  these 
proved  failures.  No  combination  was  attempted  in  the  fine  and 
medium  fine  branches  of  the  industry  where  the  labor  cost, 
per  pound  of  yarn  or  yard  of  cloth,  exceeded  the  unit  labor 
costs  in  the  production  of  the  coarsest  grades  of  textiles. 
Cotton  manufacturers  predicted  at  the  time  each  of  these 
combinations  was  formed  that  the  anticipated  economies  due 
to  consolidation  would  not  be  realized.  Some  manufacturers 
predicted  financial  disaster  for  any  combination  of  cotton  mills 
which  sought  to  introduce  large-scale  methods  of  production. 


XVII]  THE  LAW  OF  BALANCED  RETURNS  197 

In  the  case  of  the  Mount  Vernon- Woodberry  consolidation, 
which  manufactured  only  coarse  goods,  using  chiefly  heavy 
looms  and  low-intelligence  labor,  it  was  admitted  that  the 
chance  of  success  was  greater  than  if  a  combination  of  New 
England  medium-goods  mills  had  been  attempted.  The  reason 
given  was  invariably  that  all  the  economies  of  mere  size  of 
output  could  be  obtained  in  a  medium-sized  mill,  and  that 
problems  of  maintaining  a  high  rate  of  production  presented 
almost  insuperable  difficulties  in  larger  units  or  combinations 
of  units.  This  judgment  is  so  generally  acknowledged  among 
textile  operators  that  it  represents  almost  a  consensus  of  ex- 
perts. So  far  as  actual  experience  is  concerned  the  history  of 
the  three  companies  which  attempted  to  secure  the  economies 
of  large-scale  production  is  highly  instructive.  The  Mount 
Vernon-Woodberry  consolidation  of  coarse-goods  mills  was 
consistently  a  failure  for  upwards  of  fifteen  years,  during  which 
time  other  smaller  duck  mills  of  Baltimore  county  proved  suc- 
cessful. After  three  successive  reorganizations  it  was  divided 
into  two  separate  parts.  Each  part  then  passed  under  the 
control  of  a  different  and  independent  management.  The  New 
England  Cotton  Duck  Company  failed  twice.  Ultimately  one 
mill  after  another  was  sold  to  independent  textile  operators. 
It  is  important  to  note  that  the  separate  dismembered  parts 
of  the  consolidation  under  separate  and  independent  managers 
were  all  conspicuously  successful,  whereas  in  combination 
these  mills  had  failed.  The  third  combination  of  cotton  mills 
failed,  and  was  then  divided  into  parts. 

Sigfnificance  of  the  Law  for  Corporation  Executives. — • 
This  law  of  balanced  return,  as  it  is  called  here,  is  merely 
a  general  working  hypothesis  for  the  corporation  official,  to 
indicate  the  extent  to  which  a  given  type  of  business  may  be 
expanded.  It  is  not  exact.  It  is  the  balance  between  two 
opposing  forces,  a  balance  between  the  quantity  of  capital  and 


.198  CORPORATION  FINANCE  [XVII 

labor  on  the  one  hand,  and  the  quantity  of  product  on  the 
other  hand.  Economies  are  inevitable  as  the  business  in- 
creases in  size.  These  economies  are,  specifically,  different  in 
different  businesses,  but  in  general  are  connected  with  those 
parts  of  the  business  which  are  not  concerned  with  personal 
judgment  or  individual  skill  and  attention  to  detail.  The 
economies  are  incidental  to  the  automatic  phases  of  the  busi- 
ness. On  the  other  hand,  as  the  business  increases  certain 
wastes  creep  in  which  increase  with  greater  rapidity  than  do 
the  economies.  These  wastes,  in  contrast  to  the  economies, 
pertain  to  all  phases  of  the  business  where  personal  skill  is 
required.  They  pertain  to  what  one  might  call  the  "humanities" 
of  business.  The  critical  point  in  the  expansion  of  any  busi- 
ness is  reached  when  the  wastes  incident  to  mere  size  overcome 
the  economies.  Before  this  point  is  reached  the  economies  in- 
crease more  rapidly  than  do  the  wastes;  beyond  this  point  the 
wastes  exceed  the  economies.  To  determine  the  point  Is,  as 
suggested  before,  a  matter  of  very  nice  business  judgment. 
Men  who  otherwise  command  that  remarkable  combination 
of  shrewdness  and  courage,  of  unemotional  judgment  and  in- 
tuitive daring  which  distinguishes  the  truly  great  business 
executive,  fail  in  this  very  matter  of  perceiving  the  point  of 
expansion  beyond  which  their  business  suffers  from  the  prac- 
tical application  of  the  law  of  balanced  return. 

Social  Aspects. — The  social  aspect,  too,  of  the  law  of 
balanced  returns  has  great  importance.  It  has  been  contended 
by  the  socialists  and  those  having  a  socialistic  slant  to  their 
political  philosophy  that  modern  conditions  of  production  in- 
evitably tend  toward  large-scale  units  the  ultimate  outgrowth  of 
which  is  government  ownership  and  operation.  If  the  law  of 
balanced  returns  is  true,  though  only  in  its  general  implications, 
this  contention  is  not  true.  For  the  very  heart  of  the  principle 
is  that  in  many  industries  large-scale  production  is  not  essential, 


XVII]  THE  LAW  OF  BALANCED  RETURNS  199 

indeed  is  not  even  so  economical  as  small-scale  production.  In 
those  industries,  clearly,  economic  conditions  of  production  do 
not  demand  the  large-scale  unit.  So  that  the  social  order  can- 
not, in  the  interest  of  increased  economy  of  production,  demand 
either  the  adoption  of  large-scale  units  throughout  industry 
or  a  state  control  over  industry  predicated  on  the  gradual  sub- 
stitution of  regulated  monopolies  instead  of  unregulated  com- 
petition. Small-scale  production  with  attendant  unrestricted 
competition  is,  by  the  very  nature  of  certain  industries,  destined 
to  remain;  and  state  operation  of  these  industries  attempting 
to  apply  to  them  large-scale  production,  w^ould  inevitably  lead 
to  increased  costs. 


CHAPTER  XVIII 

EXPANSION    AMONG    BIG   AND   LITTLE 
MANUFACTURING  CONCERNS 

General  Considerations  Bearing  on  Expansion. — It  is  not 
easy  to  determine  whether  or  not  a  small  manufacturing  busi- 
ness should  be  enlarged.  The  principle  underlying  the  law 
of  balanced  returns,  discussed  in  the  preceding  chapter,  is 
suggestive  but  it  is  not  conclusive  or  applicable  to  all  cases. 
The  constructive  power  of  unusual  business  ability  on  the  part 
of  executives  must  always  remain  an  indeterminate  and  un- 
predictable element  in  any  business  forecast.  Nevertheless, 
there  are  certain  general  considerations  of  business  policy 
which  bear  directly  on  the  question  of  whether  or  not  it  pays 
to  expand  a  small  manufacturing  business  into  a  large  one. 
From  the  point  of  view  of  the  science  of  economics  it  is  the 
problem  of  the  efficacy  and  wisdom  of  large-scale  production; 
and  from  the  point  of  view  of  social  theory  it  is  the  "trust" 
problem. 

Historical    Survey    of     Industrial     Consolidations The 

large  manufacturing  corporation  is  of  very  recent  develop- 
ment in  the  industrial  organization  of  society.  The  great 
combinations  of  manufacturing  establishments — the  "trusts" 
so  called — appeared  suddenly  during  the  closing  years  of  the 
nineteenth  century;  quickly  and  with  little  warning,  they 
reached  their  climax,  and  then  gradually  shrunk  to  inconspicu- 
ous proportions.  In  1880  there  was  nothing  analogous  to  an 
industrial  trust  or  consolidation  in  the  sense  that  the  term 
was  used  later.  By  1888  several  industries  were  dominated 
by  large  consolidations,  such  as  the  Standard  Oil  "trust."     By 

200 


XVIII  ]     EXPANSION  IN  MANUFACTURING  CONCERNS  201 

1890  the  tendency  had  reached  such  proportions  that  pubHc 
opinion,  thoroughly  aroused  against  a  movement  in  industry 
which  seemed  to  threaten  the  stabihty  of  democratic  institu- 
tions, brought  about  the  passage  of  the  Sherman  Anti-Trust 
Act.  The  movement  toward  industrial  consolidations  stopped 
abruptly  with  the  panic  of  May,  1893,  and  remained  dormant 
during  the  depression  of  the  succeeding  three  years.  It  started 
in  afresh  with  renewed  vigor  in  1897,  when  the  first  pulsa- 
tions of  returning  prosperity  began  to  quicken  business  enter- 
prise. It  again  reached  a  climax  about  1901,  and  again  ceased 
altogether  with  the  industrial  depression  of  1903.  Since  1905 
there  have  been  sporadic  instances  of  industrial  consolidations 
but  no  general  movement  analogous  in  magnitude  or  signifi- 
cance to  the  consolidations  of  the  closing  years  of  the  last 
century. 

I.  The  Minor  Cycle. — The  occurrence  of  these  consolida- 
tions seems  to  fall  into  two  cycles.  The  earlier  or  minor  cycle, 
so  called  because  the  consolidations  were  fewer  in  number 
and  smaller  in  size,  began  in  the  years  immediately  following 
the  depression  of  the  middle  eighties — a  depression  caused  by 
the  failure  of  numerous  overextended  railroads.  The  consoli- 
dations formed  at  this  time  were  of  the  typical  trust  form  of 
organization,  in  which  a  board  of  directors  assumed  ownership 
of  the  corporate  shares  of  numerous  small,  previously  compet- 
ing concerns.  The  trusts  stifled  competition  effectually,  but 
in  so  doing  thoroughly  aroused  public  opinion  against  them. 
They  were  very  small  at  first.  It  is  reported  that  about  1882 
the  professor  of  political  economy  in  one  of  the  eastern 
universities  was  much  concerned  over  a  combination  of  thread 
mills  in  Connecticut,  with  a  capitalization  of  $1,000,000.  He 
is  said  to  have  remarked  to  his  classes  that  the  formation  of 
a  manufacturing  enterprise  of  this  magnitude  was  an  unpre- 
cedented event  in  the  industrial  world.     Perhaps  it  was.    This 


202  CORPORATION  FINANCE  [  XVIII 

was  in  the  early  eighties.  Within  ten  years  combinations  had 
been  formed  with  capital  in  excess  of  $100,000,000  and  within 
twenty  years  a  combination  of  steel  plants  had  been  formed 
with  a  total  capitalization  in  excess  of  $1,000,000,000.  As 
they  grew  in  size  and  number  they  were  seen  in  the  garb  of 
a  social  menace,  and  became  the  dominating  social  and  politi- 
cal "problem"  demanding  a  legislative  solution;  the  Sherman 
Anti-Trust  Act  of  1890  was  the  response  of  a  feverishly 
aroused  Congress. 

2.  The  Major  Cycle. — The  later  or  major  cycle  of  indus- 
trial consolidations  began  in  1897.  It  was  among  the  first 
outward  signs  of  the  returning  prosperity  following  the  stag- 
nation consequent  upon  the  panic  of  1893.  At  first  the 
consolidations  were  few  in  number,  but  the  movement,  once 
begun  again,  quickly  reached  far  beyond  anything  thought 
of  in  the  preceding  period.  Every  conceivable  line  of  manu- 
facturing had  its  trust.  Conservative  bankers,  shrewd  busi- 
ness men,  and  doctrinaire  economists  became  infected  with  the 
virus  of  large-scale  production.  People  condemned  the  trusts 
one  moment  and  bought  their  securities  in  the  next.  It  was 
the  harvest  time  of  promoters.  By  the  end  of  1899  more  than 
130  consolidations  of  considerable  magnitude  had  been  organ- 
ized, all  for  the  sole  purpose  of  suppressing  competition  and 
increasing  the  scale  of  production.  During  1900  and  1901 
the  movement  continued,  but  the  new  promotions  were  fewer 
in  number,  owing  to  the  fact  that  most  opportunities  for  the 
formation  of  "trusts"  had  already  been  fully  exploited  by  the 
bankers  and  promoters.  Accordingly  the  ground  was  combed 
over  again.  The  trusts  themselves  were  consolidated.  A 
pyramid  was  built  of  pyramids.  The  United  States  Steel 
Corporation  capitalized  at  over  $1,300,000,000,  was  built 
up  out  of  half  a  dozen  smaller  "trusts,"  themselves,  in  several 
cases  the  combinations   of   smaller   combinations.      By    1902 


XVIII]     EXPANSION  IN  MANUFACTURING  CONCERNS  203 

signs  were  apparent  that  many  of  the  trusts  had  not  justified 
the  predictions  of  their  promoters.  The  pubhc  investors 
became  suspicious.  Stock  market  quotations  of  speculative 
industrial  common  stocks  became  at  first  unsteady  and  then 
began  to  fall.  New  promotions  became  infrequent  and  several 
embryonic  consolidations  were  stifled  at  their  birth.  By  1903 
a  veritable  panic  occurred  in  the  stocks  of  industrial  consoli- 
dations and  new  promotions  ceased  altogether.  An  industrial 
depression  ensued. 

During  1905  and  1906  few  consolidations  were  formed, 
and  these  few  were  of  only  minor  importance.  After  the 
depression  following  the  panic  of  1907  there  were  occasional 
consolidations  of  industrial  businesses,  more  especially  in  the 
retail  merchandising  and  automobile  industries.  Yet  after 
all  is  said,  the  evidence  is  clear  that  during  the  period  from 
1902  down  to  the  opening  of  the  Great  War  the  number  of 
industrial  consolidations  was  insignificant  compared  with 
the  period  of  fifteen  years  preceding  the  depression  of  1903. 

Reasons  for  Cessation  o£  Industrial  Consolidations. — 
Several  highly  significant  reasons  explain  why  the  movement 
toward  consolidations  ended  as  quickly  as  it  did. 

Unrealised  Economies.  Paramount  is  the  simple  fact 
that  as  a  whole  the  trusts  had  turned  out  ill.  They  failed 
to  meet  the  expectations  of  their  promoters.  Competition  was 
not  suppressed  and  the  widely  heralded  economies  of  large- 
scale  production  were  not  realized.  And  in  cases  of  failure 
many  evidences  of  fraud  in  the  conduct  of  the  trusts  came 
to  light. 

The  Changed  Attitude  of  the  Law.  A  second  reason  for 
the  almost  total  cessation  of  industrial  promotions  was  the 
changed  attitude  of  the  law.  Although  the  Sherman  Act  was 
passed  in  1890,  it  was  not  until  early  in  1895  that  an  important 
case  under  this  act  was  reviewed  by  the  United  States  Supreme 


204  CORPORATION  FINANCE  [XVIII 

Court.  The  decision  of  the  highest  court  then  indicated 
clearly  that  industrial  consolidations  were  to  be  considered 
legal.  The  court  let  them  pass  by  a  verbal  subterfuge,  not- 
withstanding the  spirit  of  the  act.  But  in  1899  the  Supreme 
Court  reversed  itself.  Consolidations  were  not  to  be  legalized 
by  a  mere  verbal  subterfuge.  The  act  of  1890  did  apply  to 
the  combinations  of  manufacturing  plants  and  could,  more- 
over, be  invoked  to  dismember  those  which  had  been  illegally 
formed.  But  this  idea  did  not  vividly  and  thoroughly  per- 
meate the  intelligence  of  the  banking  world  until  the  great 
Northern  Securities  decision  in  1903,  when  the  teeth  of  the  act 
of  1890  were  felt.  This  decision  was  widely  advertised  and 
the  country  as  a  whole  realized  that  the  act  of  1890  was  not 
dead  legal  verbiage,  but  meant  exactly  what  it  said — namely, 
that  consolidations  of  competing  enterprises  were  illegal. 

The  Shift  of  Investment  Sentiment.  A  third  reason  that 
explains  the  decline  of  industrial  promotions  after  1903  was 
the  shift  of  investment  sentiment.  Bankers  and  investors 
turned  from  manufacturing  enterprises,  where  competition 
could  not  be  inhibited  by  combination,  to  public  service  enter- 
prises, where  competition  was  legally  prohibited  by  means 
of  the  exclusive  franchise. 

Recent  Consolidations. — But  beginning  in  the  autumn  of 
191 5,  as  a  direct  consequence  of  the  enormously  increased 
demand  for  manufactured  products,  the  rapidly  rising  prices, 
the  loosening  of  restrictions  on  monopoly — all  economic  con- 
comitants of  a  great  war — a  new  movement  toward  industrial 
combinations  began.  These  recent  consolidations  differ  in 
many  important  respects  from  the  consolidations  of  twenty 
or  more  years  before.  In  the  first  place,  no  attempt  is  made 
to  secure  all  the  plants  in  a  given  industry — good,  bad,  and 
indifferent — in  the  confident  hope  that  thereby  competition 
can  be  suppressed.     On  the  contrary  the  purpose  is  to  select 


XVIII]     EXPANSION  IN  MANUFACTURING  CONCERNS  205 

relatively  few  plants  and  these  are  chosen  on  the  basis  of 
efificiency  of  operation.  Very  often  the  chief  purpose  is  to 
secure  more  capital  for  an  old-established  industry,  either  from 
bankers  or  the  public.  The  consolidation  of  separate  and 
independent  plants  is  a  mere  incident  to  expansion.  New- 
capital  rather  than  the  suppression  of  competition  is  held  to 
be  essential  to  success. 

The  Presumptions  of  the  "Trust  Movement." — The  prem- 
ises upon  which  the  "trust  movement"  was  based  were  simple 
— suppression  of  competition  and  economies  of  large-scale 
production.  Owing  to  the  fact  that  the  Sherman  Act  of  1890 
was  directed  against  all  consolidations,  the  intent  of  which 
was  to  suppress  competition,  the  former  motive  was  not 
publicly  acknowledged.  It  was  implicitly  recognized,  how- 
ever, and  explicitly  stated  in  terms  of  the  number  of  impor- 
tant competitors  that  were  included  in  the  consolidation  and 
the  relatively  large  output  to  be  controlled  by  the  new  company. 

The  reasons  usually  emphasized  to  support  the  prophecy 
that  the  consolidated  company  would  earn  more  than  the 
previous  competing  companies,  were  based  on  the  presump- 
tions of  the  economics  of  large-scale  production.  Much 
argument  was  advanced  to  support  the  general  contention 
that  the  "big  company"  could  buy  its  raw  materials  and 
manufacture  and  distribute  its  products  more  cheaply  than  a 
small   company. 

The  entire  line  of  reasoning  assumed  that  the  planning 
and  responsibility  could  be  centralized  at  the  head,  and  that 
all  the  other  parts  of  the  business  organization  needed  only  to 
function  in  set  lines  of  routine  practice;  a  pattern  of  a  business 
could  be  constructed  and  the  business  would  succeed,  if  only 
the  pattern  were  followed.  By  substituting  the  automatic 
machine  for  hand  labor,  routine  intelligence  had  been  dispensed 
with  in  the  shop  and  the  rate  of  production  enormously  in- 


206  CORPORATION  FINANCE  [XVIII 

creased;  by  substituting  the  automatic  system  for  reasoning, 
executive  intelligence  could  be  dispensed  with  and  the  rate 
of  production  enormously  increased. 

The  Failure  of  Industrial  Consolidations. — In  order  to 

test  empirically  the  soundness  of  these  presumptions  35  in- 
dustrial consolidations  were  used  as  the  basis  for  comparing 
the  earnings  of  what  might  be  called  a  "typical"  or  "average" 
consolidation  with  those  of  the  competing  plants  before  the 
consolidation  was  effected.  A  direct  comparison  was  made 
between :  ( i )  the  earnings  of  the  separate  competing  plants 
prior  to  consolidation,  (2)  the  anticipated  earnings  that  would 
result  from  consolidation,  and  (3)  the  actual  earnings  after 
the  consolidation  had  been  effected.  As  a  result  of  the  statistical 
study  it  was  found  that  the  earnings  of  the  separate  plants 
before  consolidation  were  a  fifth  greater  than  the  earnings  of 
the  same  plants  after  they  had  been  combined.  This  was 
using  the  first  year  of  the  consolidation  as  the  basis  of  judg- 
ment. Moreover,  the  earnings  of  this  first  year  were  only 
some  60  per  cent  of  what  the  promoters  in  their  overconfident 
prospectuses  had  estimated  that  they  would  be.  The  later 
earnings  proved  no  more  encouraging.  In  fact,  these  first- 
year  earnings  were  about  a  tenth  greater  than  the  average 
earnings  during  the  lo-year  period  following  the  consolida- 
tion, and  distinctly  greater  than  those  of  the  tenth  year — after 
the  business  organization  had  been  thoroughly  "settled"  and 
the  plants  enlarged,  rehabilitated,  and  technically  adjusted 
to  each  other's  operation. 

These  were  the  actual  results  as  shown  by  statistical  analysis. 
In  the  light  of  the  anticipated  economies  of  production  and 
distribution  the  industrial  consolidation  was  a  failure. 

Reasons  for  Failure. — We  have  not  far  to  seek  to  find 
certain  reasons  for  this  unexpected  but  nevertheless  certain 


XVIII]     EXPANSION  IN  MANUFACTURING  CONCERNS  207 

failure.  Foremost,  perhaps,  is  the  diffusion  of  responsibilty.  A 
man  with  ample  business  skill  to  manage  a  small  factory  was 
given  the  management  of  a  group  of  plants  widely  separate 
and  each  operating  under  local  conditions.  He  was  then 
compelled  to  delegate  the  actual  management  to  paid  superin- 
tendents, over  none  of  whom  he  had  more  than  indirect 
authority.  If  he  tried  to  manage  the  scattered  plants  as  he 
had  his  single  plant,  he  found  that  the  enormous  detail  in- 
volved too  great  a  burden  for  his  mind;  important  matters 
passed  unnoticed  and  the  local  superintendents  degenerated 
into  automatic  parts  of  a  machine,  without  initiative  or  power 
of  assuming  responsibility.  (As  the  large  manufacturer  once 
expressed  it — there  comes  a  point  where  the  man  in  the 
twentieth  story  of  an  office  building  cannot  make  up,  no  matter 
how  brilliant  he  may  be,  for  the  waste  and  shiftlessness  of  a 
variety  of  superintendents  in  many  mills  hundreds  of  miles 
away  in  all  directions.)  If,  on  the  other  hand,  he  dele- 
gated a  large  share  of  the  authority  to  his  local  superintendents 
he  found  that  he  required  men  of  marked  business  ability  to 
manage  the  separate  plants  efficiently;  he  required,  in  fact, 
a  degree  of  ability  which  commanded  so  high  a  salary  as  to 
absorb  the  presumptive  economies  due  to  consolidated 
management. 

Again  lack  of  knowledge  of  individual  employees  is  a 
difficulty.  A  successful  competitor  of  a  large  consolidation 
declared  that  his  success  was  due  to  the  fact  that  he  knew 
the  parents  and  grandparents  of  the  employees  in  his  mill. 
He  had  watched  them  from  childhood.  He  knew  the  skill 
and  deficiencies  of  each  and  therefore  the  kind  of  work  and 
the  condition  which  would  bring  out  the  greatest  earning 
power  of  each.  Such  possibilities  of  individualized  super- 
intendence of  labor  were  impossible  where  the  organization 
had  grown  so  large  that  all  personal  contact  between  employer 
and  employee  was  lost. 


208  CORPORATION  FINANCE  [XVIII 

Lack  of  loyalty  of  officers  and  directors  is  often  one  out- 
come. In  order  to  maintain  the  continuity  of  the  separate 
businesses  it  was  the  custom  to  have  the  more  prominent  men 
who  had  disposed  of  their  plants  to  the  consolidation  serve 
as  members  of  the  board  of  directors,  or  as  managing  officers 
of  the  corporation.  But  the  center  of  their  loyalty  was 
changed.  They  were  no  longer  operating  their  own  plants. 
Personal  motives  easily  supplanted  any  feelings  of  responsibility 
they  might  have  toward  the  great  body  of  stockholders.  As 
directors  they  were  tempted  to  burden  the  consolidation  with 
useless  plants  at  personal  profit,  or  to  make  advantageous 
contracts  with  other  companies  in  which  they  were  interested, 
or  give  employment  to  relatives  at  high  salaries.  They  were 
tempted  to  speculate  in  materials  in  such  wise  that  the  burden 
of  loss  fell  on  the  corporation,  or  to  purchases  and  sales  of 
the  corporations'  securities,  based  on  knowledge  exclusively 
their  own.  If  the  body  of  stockholders  found  fault  with  such 
codes  of  business  ethics  the  directors  could  resign  their  posi- 
tions and  sell  their  securities.  They  could  even  enter  into 
competition  with  the  consolidation  and  grow  strong  through 
a  knowledge  of  the  trade  enhanced  by  their  previous 
connections. 

Lack  of  attention  to  the  laborious  parts  of  the  business  by 
the  higher  officials  is  almost  certain.  The  directors  considered 
their  positions  too  important  and  their  time  too  valuable  to 
spend  on  matters  of  detail.  Previously,  as  owners  of  com- 
petitive plants,  they  were  at  their  business  offices  each  day 
from  early  in  the  morning  to  late  in  the  afternoon;  as  "vice- 
presidents"  they  were  more  often  at  the  office  of  the  corpora- 
tion from  lo  until  3  o'clock,  and  not  at  all  on  Saturdays.  They 
no  longer  felt  obliged  to  sacrifice  social  pleasures  for  business 
motives.  They  were  no  longer  concerned  with  petty  economies 
of  manufacture,  insignificant  alone,  but  large  in  aggregate. 
Even    in   the   utilization   of   by-products,   where   one   of    the 


XVIII]     EXPANSION  IN  MANUFACTURING  CONCERNS  209 

economies  of  large-scale  production  was  supposed  to  lie,  the 
executive  officers  would  frequently  take  the  position  that  the 
possible  advantage   was  too   insignificant  to   be   worth   their 
attention  and   trouble.      (There   are   two   temptations   which 
confront  every  director  in  a  large  corporation.     The  success 
with  which  a  man,  suddenly  risen  to  intiuence,  resists  the  feel- 
ing that  he  is  too  important  to  devote  himself  to  the  current 
detail  of  management  and  the  feeling  that  he  is  in  a  position 
to   profit  through   stock   market   manipulation   measures   his 
future  success  in  the  position  of  responsibility.     No  human 
mind  is  great  enough  to  manage  a  large  business  with  con- 
summate skill  and  follow  in  detail  the  market  quotations  of 
its  securities.    It  is  a  modern  instance  of  serving  two  masters.) 
Customers  do  not  always  like  the  machinelike  methods. 
There  was,  and  still  is,  a  group  of  men  who  are  so  blinded  by 
an  external  appearance  of  efficiency  that  they  have  come  to 
think  that  the  more  automatic  and  impersonal  a  business  be- 
comes the  greater  will  be  its  productive  power.     Fortunately 
this  theory  is  no  longer  widely  held.    But  at  the  time  the  indus- 
trial consolidations  were  created  it  was  popular.     As  a  conse- 
quence the  central  management  undertook  to  substitute  a  more 
scientific  and  carefully  articulated  method  of  producing  and 
selling  goods  for  the  slipshod  methods  of  the  small  establish- 
ments.    In  cases  of  a  standardized  product  the  application  of 
more  scientific  methods  to  production  were  undoubtedly  wise, 
but  in  all  branches  of  the  selling  organization  they  were  an 
absolute    failure.      Few   things   count   more    in    salesmanship 
than  the  personal  magnetism  of  an  able  salesman  basing  his 
appeal  on  long-established  trade  connections.     The  directors 
of  the  consolidation   sought   in  the   interest   of   organization 
and  economy  to  replace  high-salaried  salesmen  by  low-paid 
order  clerks.    Many  of  these  salesmen  had  been  the  proprietors 
of    the   old    businesses,    men    who    held    their    customers    by 
family  association — the  customers  of  their  grandfathers  and 

14 


2IO  CORPORATION  FINANCE  [  XVIII 

greatgrandfathers,  perhaps.  "Among  the  oldest  houses  doing 
business  with  us"  was  a  bond  which  the  force  of  circumstances 
broke  with  difficuhy.  Instead  of  profiting  through  this  bond 
the  new  order  of  scientific  salesmanship  interposed  the  deaden- 
ing influence  of  organization  between  buyer  and  seller.  Cus- 
tomers found  that  they  were  no  longer  dealing  with  the  son 
of  their  old  friend  but  with  some  cog  in  the  machine  designated 
as  ABC.  Before,  they  had  arranged  the  terms  of  their  con- 
tracts in  a  dingy  office,  replete  with  the  memories  of  half  a 
century;  now  their  contracts  were  forwarded  to  them  from 
the  central  office  or  delivered  to  them  by  the  manager's  secre- 
tary.    As  a  result  they  often  turned  elsewhere. 

Mere  size  in  itself  often  proves  a  handicap  in  competition 
with  the  smaller  and  more  mobile  competitors,  especially 
in  making  the  large  company  less  able  to  withstand 
depressions  in  the  trade.  Moreover,  instead  of  getting 
raw  materials  at  a  lower  cost  the  large  company 
found  it  more  hazardous  to  contract  for  the  large 
quantities  required  for  sustained  production,  partly  because 
the  very  publicity  of  the  company's  demands  tended  to  raise 
the  prices  it  was  forced  to  pay.  This  was  conspicuously  true 
if  the  consolidated  company  used  a  raw  staple  product,  such 
as  cotton,  wool,  corn,  or  pig  iron.  The  large  orders  had  to  be 
placed  openly,  often  with  one  of  two  or  three  large  producers 
who  alone  were  able  to  guarantee  deliveries.  If  the  raw 
materials,  like  cotton  or  corn,  were  quoted  openly  on  one  of 
the  exchanges,  the  consolidated  company's  buyers  were  forced 
to  supply  the  needs  at  the  open  contract  prices.  A  small  com- 
petitor with  a  relatively  small  total  demand  could  "shop 
around"  the  market,  purchasing  secretly  odd  lots  at  a  marked 
concession  from  the  published  prices.  In  many  instances, 
therefore,  "quantity  purchases"  proved  a  disadvantage  rather 
than  an  advantage.  During  the  early  years  of  the  starch  and 
glucose  consolidation  a  small  competitor  made  himself  con- 


XVIII]     EXPANSION  IN  MANUFACTURING  CONCERNS  211 

spicuously  troublesome  by  closing  down  his  factory  during 
periods  of  small  demand — when  heavy  overhead  charges  made 
operation  unprofitable — and  starting  it  up  when  the  demand 
returned,  using  odd  lots  of  ungraded  corn.  In  this  manner 
he  was  able  to  produce  glucose  much  cheaper  than  it  could  be 
made  by  the  consolidation.  By  bidding  under  the  prices  asked 
by  the  consolidation  he  could  sell  just  enough  glucose  to  use 
up  the  amount  of  cheap  odd-lot  corn  procurable  at  any  one 
time.  But  small  as  was  his  possible  production  in  comparison 
with  that  of  the  consolidated  company,  he  made  it  impossible 
for  the  large  company  to  mantain  its  prices  uniformly  in  all 
markets. 

Again,  the  large  consolidations,  especially  in  the  first 
years  of  their  existence,  were  very  reluctant  to  substitute  im- 
proved machinery  and  equipment  for  that  acquired  with  the 
original  plants  and,  instead  of  encouraging  improvements  and 
stimulating  experimental  work,  clung  to  their  great  masses 
of  worn  and  obsolete  machinery.  Under  these  circumstances 
the  newer  competitor  with  a  thoroughly  improved  plant  ob- 
tained lower  costs  of  production. 

The  different  ways  in  which  the  consolidated  company  was 
defeated  in  securing  marked  economies  of  large-scale  produc- 
tion, and  handicapped  in  its  competitive  battle  with  smaller 
businesses  might  be  further  extended.  But  it  would  add  little 
of  general  significance.  The  important  conclusion  to  be  ob- 
tained from  a  survey  of  the  great  consolidation  movement  at 
the  close  of  the  nineteenth  century  is  that  competition  cannot 
be  inhibited  by  combination.  There  is  nothing  in  large-scale 
production,  taken  alone,  that  is  necessarily  economical. 

Economic  Laws  and  Unbridled  Expansion. — Nor  are  these 
conclusions  essentially  different  if  we  consider  the  results  of 
unbridled  expansion  where  that  expansion  represents  merely 
internal  growth  without  such  absorption  of  outside  elements 


212  CORPORATION  FINANCE  [XVIII 

as  would  permit  one  to  use  the  term  "consolidation."  Examples 
of  businesses  having  attained  a  national  scope  through  mere 
growth  are  not  as  common  as  businesses  that  have  become 
great  by  consolidation.  But  having  become  great  they  are 
subject  to  the  same  economic  laws.  During  their  period  of 
growth  they  represent  usually  the  work  of  a  single  man.  In 
his  youth  and  prime  this  man  is  a  veritable  business  genius. 
He  overcomes  difficulties ;  he  stifles  competition.  His  company 
gradually  but  steadily  forges  to  the  head.  It  may  even  become 
the  largest  single  factor  in  the  industry.  But  once  the  man 
has  passed  his  prime  the  same  failure  to  observe  the  ineffective- 
ness of  mere  size  creeps  in  as  in  the  case  of  a  direct  consolida- 
tion. The  business  becomes  too  big  for  a  single  man,  now 
passing  beyond  middle  life,  or  for  the  group  of  subordinates 
to  whom  he  has  to  entrust  executive  administration.  In  order 
to  strengthen  itself  in  one  or  another  direction  the  business 
has  probably  branched  out  into  allied  or  even  different  lines  of 
enterprise.  Some  of  these  prove  profitable,  others  do  not. 
Large  amounts  of  liquid  capital  are  absorbed  in  an  endeavor 
to  maintain  and  increase  the  volume  of  sales.  And  when  the 
whole  situation  is  analyzed  it  will  be  found  that  the  business 
has  actually  fallen  back,  when  measured  in  return  on  invested 
capital,  during  the  time  when  it  has  apparently  gone  forward, 
if  measured  in  terms  of  A^olume  of  sales.  If  wastes  and  mis- 
takes of  management  are  too  pronounced,  especially  if  they 
develop  rapidly  at  a  time  of  financial  panic,  the  business  fails. 

The  two  largest  mercantile  failures  during  the  last  twenty 
years  meet  these  conditions  exactly.  The  Westinghouse 
Electric  and  Manufacturing  Company  was  built  up  from  an 
insignificant  beginning  to  one  of  the  largest  factors  in  the 
electric  industry  in  the  world,  through  the  business  genius  of 
George  Westinghouse.  But  the  business  expanded  too  rapidly 
and  became  unwieldy;  it  exhausted  its  working  capital  and 
failed  in  the  panic  of  1907. 


XVIII]     EXPANSION  IN  MANUFACTURING  CONCERNS  213 

Horace  B.  Claflin  started  a  wholesale  dry  goods  business 
in  1843  in  New  York.  By  the  end  of  the  Civil  War  the  sales 
of  H.  B.  Claflin  and  Company  had  reached  $64,000,000.  The 
business  steadily  increased  until  the  death  of  H.  B.  Claflin  in 
1885.  The  house  was  at  the  time  the  largest  wholesale  job- 
bing house  in  the  country — possibly  in  the  world.  The  net 
annual  earnings  amounted  to  approximately  $700,000.  Mean- 
while smaller  dry  goods  jobbing  houses  sprang  up  in  the  West 
and  this  movement  developed  rapidly  after  the  depression  of 
1884.  The  specialty  jobber  also  came  into  prominence.  These 
tendencies  were  recognized  by  H.  B.  Claflin,  who  at  the  time 
of  his  death  was  entering  the  importing  and  manufacturing 
fields.  The  son,  John  Claflin,  sought  to  follow  his  father's 
aggressive  policies,  but  lacked  the  judgment.  Seeing  the  job- 
bing business  slipping  away  to  smaller  competitors,  he  sought 
to  preserve  his  position  and  stabilize  his  market  by  establishing 
a  chain  of  department  stores  all  over  the  country — upwards  of 
40  in  all.  Over  these  extensions  John  Claflin  exercised  the 
most  indirect  methods  of  control.  The  sales  policies  of  the 
retail  stores  were  inefficient  and  antiquated.  Their  accounting 
systems  permitted  the  local  managers  to  deceive  the  central 
office  regarding  their  true  value.  There  was  no  standardiza- 
tion of  purchases  and  no  attempt  to  pool  purchases  so  as  to 
obtain  quantity  discounts.  Many  of  these  stores  were  pur- 
chased from  the  proceeds  of  the  discount  of  ordinary  com- 
mercial notes  bearing  the  Claflin  name,  so  that  what  purported 
to  be  commercial  notes  secured  by  quick  assets  were  really  only 
financial  notes  backed  by  the  rapidly  declining  good-will  of 
scattered  and  poorly  managed  department  stores.  Finally  in 
June,  1914,  the  banks  withdrew  further  extensions  of  credit 
and  the  structure  collapsed.  Ordinarily,  however,  the  results 
are  not  so  dramatic.  The  big  business  merely  continues  to 
exist,  yielding  a  lower  return  to  its  proprietors,  proportion- 
ately to  the  capital  invested  and  the  volume  of  business,  than 


214  CORPORATION  FINANCE  [XVIII 

is  the  case  with  its  smaller  competitors  in  the  same  industry. 

Successful  Types  of  Consolidation — i.  Automatic  and 
Integrated  Industries. — It  is  not  true,  however,  that  all  con- 
solidations and  expansions  are  unsuccessful.  As  suggested 
in  the  discussion  of  the  law  of  balanced  returns,  certain  kinds 
of  enterprise,  such  as  heavy  metal  industries,  lend  themselves 
to  large-scale  production. 

A  type  of  enterprise  in  which  consolidation  has  been  of 
obvious  benefit  is  in  those  industries  in  which  it  is  possible 
to  reach  back  to  the  primal  raw  material  and  forward  to  the 
ultimate  consumer.  This  is  known  as  "integration."  A  busi- 
ness concern,  originally  controlling  only  an  intermediate 
process  of  manufacture,  acquires  by  consolidation  another 
concern  which  produces  its  chief  raw  material  and  still  an- 
other which  distributes  to  retailers  or  even  to  consumers  its 
finished  products.  A  furniture  factory,  for  illustration,  ac- 
quires a  lumber  company  on  the  one  hand  and  a  furniture 
jobbing  business  or  even  a  chain  of  retail  stores  on  the  other 
hand.  In  this  way  it  controls  the  entire  course  of  the  furniture 
production  and  distribution,  from  the  forest  to  the  home.  A 
shoe  factory  reaches  back  and  acquires  a  series  of  tanneries, 
and  forward,  to  acquire  a  chain  of  retail  shoe  stores.  An 
automobile  tire  company  acquires  a  fabric  mill  and  cotton 
acreage;  a  rubber  concern  acquires  plantations  in  Ceylon. 
These  combinations  are  certainly  not  always  successful,  be- 
cause the  close  integration  removes  the  spur  of  competitive 
buying  and  selling  at  the  different  stages  of  manufacture  and 
distribution,  but  many  of  them  have  turned  out  well,  especially 
if  no  great  administrative  ability  is  required  in  conducting 
the  subordinate  or  "tacked-on"  businesses.  Besides  effecting 
such  economies  as  the  closer  union  makes  possible,  the  producer 
of  the  material  at  any  one  stage  can  regulate  its  production 
in  accordance  with  the  known  demands  of  the  next  higher 


XVIII J     EXPANSION  IN  MANUFACTURING  CONCERNS  215 

stage.  The  whole  process  of  production  and  distribution  is 
therefore  less  susceptible  to  fluctuation  than  when  each  unit 
is  producing  for  a  competitive  and  uncontrollable  market.  The 
expenses  and  the  wastes,  the  lost  motion  and  the  friction, 
of  selling  the  intermediate  products  is  entirely  done  away  with. 
There  is  but  one  real  sale,  that  to  the  ultimate  consumer  at 
the  end  of  the  whole  chain. 

Integration  has  been  one  of  the  chief  reasons  for  the  success 
of  the  United  States  Steel  Corporation.  It  acquired,  with  the 
old  Illinois  Steel  Company,  extensive  iron  mines  west  of  Lake 
Superior;  it  acquired,  with  the  Carnegie  Steel  Company,  a 
railroad  from  Lake  Erie  to  Pittsburgh.  Certain  of  its  con- 
stituents, like  the  American  Steel  and  Wire  Company,  the 
National  Tube  Company,  and  the  American  Bridge  Company, 
manufactured  and  sold  fabricated  steel  products  to  the  ultimate 
consumer.  The  Steel  Corporation  acquired  coking  coal  and 
limestone  deposits,  coke  ovens,  and  pig  iron  furnaces.  It 
organized  numerous  intermediate  links  to  the  chain  so  that 
soon  after  its  organization  the  corporation  could  claim,  in 
truth,  that  it  carried  on  every  branch  of  the  steel  business 
from  mining  the  ore  to  the  sale  of  the  fabricated  products  to 
their  ultimate  consumers.  One  conspicuous  reason  for  the 
success  of  the  present  Corn  Products  Refining  Company  under 
the  Bedford  management  has  been  the  fact  that  it  has  directed 
its  chief  efforts  to  produce  end  products  sold  directly  to  the 
ultimate  consumers  rather  than  intermediate  products  sold  to 
other  manufacturers.  It  even  acquired  control  of  companies 
which  produced  the  end  products  when  this  course  seemed 
preferable  to  developing  a  market  of  its  own.  The  number  of 
instances  in  which  this  kind  of  vertical  consolidation  has  taken 
place  within  recent  years  is  very  large. 

2.  Chain  Stores. — The  systems  of  chain  stores  are  com- 
binations of  another  kind  which  are  usually  successful.     The 


2l6  CORPORATION  FINANCE  [XVIIl 

capital  employed  here  is  not  invested  in  machinery  but  used 
to  give  great  buying  power  and  the  chance  of  taking  advantage 
of  all  cash  discounts.  The  labor  element  is  often  reduced  to 
the  simplest  kind  of  service. 

Like  other  types  of  large  businesses  likely  to  prove  success- 
ful, a  chain  of  retail  distributing  stores  requires  for  its  manage- 
ment a  special  and  unusually  able  form  of  executive  ability. 
But  once  this  peculiar  executive  ability  is  acquired  the  length 
of  the  chain  may  be  considerably  increased  without  lowering  the 
general  efficiency  of  the  entire  management.  No  new  problems 
arise  in  the  management  of  a  consolidation  of  twenty  stores  of 
the  same  general  character,  than  existed  in  the  management  of 
five  or  ten.  No  essentially  new  executive  qualities  are  required. 
Consolidation  can  therefore  be  effected,  provided  that  the  two 
chains  of  stores  are  doing  the  same  kind  of  business,  and 
provided  also  that  the  ability  and  experience  of  management 
required  in  the  new  enterprise  differ  in  scope,  but  not  in  kind 
from  what  has  been  required  previously. 

The  type  of  retail  chain  store  that  has  proved  most  suc- 
cessful in  the  past  and  that  will  probably  be  found  most 
successful  in  the  future  is  confined  to  those  fields  of  mer- 
chandising where  individual  personal  services  of  the  store- 
keeper are  least  important,  such  as  cafeteria  restaurants, 
grocery  stores,  drug  stores,  cheap  dry  goods  and  notions  stores. 
In  a  purchase  from  a  store  of  this  kind  the  salesman  is  merely 
a  cashier.  As  the  price  paid  is  small,  the  transaction  is  com- 
pleted in  a  moment's  time;  no  credit  is  extended  and  the 
customer  carries  away  his  purchase. 

3.  Foreign  Trade  Companies. — Another  group  of  indus- 
trial combinations,  having  to  do  with  foreign  trade,  have 
proved  successful  and  are  likely  to  prove  more  so  as  inter- 
national competition  after  the  Great  War  becomes  increasingly 
intense.     So  far  as  the  United  States  is  concerned,  these  com- 


XVIII]     EXPANSION  IN  MANUFACTURING  CONCERNS  217 

binations  are  of  comparatively  recent  origin.  They  are  of  two 
distinct  classes.  The  one  class  represents  a  combination  of 
shipping  companies,  each  one  of  which  had  done  a  more  or 
less  localized  foreign  trading  business.  The  other  class  rep- 
resents a  combination  of  American  producing  companies 
organized  for  the  specific  purpose  of  exporting,  in  close  co- 
operation with  each  other,  their  surplus  production  to  foreign 
parts.  It  is  quite  possible,  as  the  business  of  our  foreign  trade 
becomes  stabilized,  that  the  two  kinds  of  export  business  will 
coalesce,  but  this  has  not  occurred  as  yet. 

Combinations  of  Exporters.  The  first  class  is  spoken  of 
as  "export  companies,"  or  "exporting  corporations."  They 
produce  no  merchandise  themselves,  but  act  merely  as  foreign 
merchants  on  a  large  scale.  Before  the  Great  War  much  of 
our  foreign  commerce  was  handled  by  agencies  or  small  ex- 
porting merchants  who  did  a  restricted  business  confined  to 
relatively  few  localities,  perhaps  to  a  single  one.  The  merchants 
and  manufacturers  of  this  country  were,  before  the  Great  War, 
so  intensely  concerned  with  exploiting  our  own  natural 
resources  and  developing  our  own  markets  that  they  entirely 
neglected  export  trade,  except  for  an  occasional  spasmodic 
onslaught  when  there  happened  to  ht  a  glut  in  our  own  domestic 
markets.  But  with  the  closing  of  neutral  markets  to  the 
European  belligerents  during  the  Great  War,  an  unprecedented 
and  extraordinary  opportunity  to  enter  foreign  trade  was 
offered  to  American  exporting  houses.  In  response  to  the 
pressure  suddenly  placed  upon  them  these  exporting  houses 
either  expanded  their  businesses  with  the  aid  of  new  capital  or 
else  combined  among  themselves  into  large,  widely  extended 
companies.  These  may,  after  they  have  thoroughly  learned  the 
foreign  business,  prove  successful.  They  command  capital  and 
widely  extended  banking  connections.  As  manufacturers' 
agents  they  are  able  to  reach  many  more  markets  than  is  possi- 
ble for  a  single  exporter.     Several  of  these  combinations  have 


2l8  CORPORATION  FINANCE  [XVIII 

embraced  smaller  organizations  with  widely  separated  agencies 
— as  a  combination  between  one  exporting  concern  doing  busi- 
ness in  Central  America  and  parts  of  the  Caribbean  Sea  and 
another  doing  business  on  the  east  coast  of  South  America. 
As  merchants  doing  exporting  for  their  own  account,  they  are 
able  to  develop  a  much  more  accurate  and  comprehensive 
understanding  of  foreign  demands  than  is  possible  for  small 
exporters  with  very  limited  markets.  In  this  manner  they  are 
able  to  exercise  far  more  intelligence  in  purchases  for  their 
foreign  accounts  than  could  the  small  exporter.  And  in  addi- 
tion to  the  wider  facilities  for  merchandising  American  pro- 
ducts, these  combinations  are  able  to  control  steamship  com- 
panies, wharves,  storage  warehouses,  besides  having  command 
of  considerable  banking  and  credit  facilities. 

Consolidations  of  Manufacturers.  The  other  class  of  in- 
dustrial export  companies  is  almost  too  recent  in  origin  to  be 
included  in  this  survey,  except  by  way  of  prophecy.  It  includes 
the  consolidations  of  manufacturers,  legalized  by  the  so-called 
Webb  bill.  Ever  since  prosecutions  under  the  Sherman  Act  of 
1890  began  to  inhibit  the  formation  of  new  consolidations  and 
cause  terror  to  those  already  formed,  business  men  who  believe 
in  large-scale  production  have  argued  for  the  need  of  consolida- 
tions on  the  ground  of  foreign  trade.  The  contention  that 
large-scale  units  of  production  in  this  country  are  required  in 
order  to  meet  successfully  the  large-scale  units  of  other 
countries  looms  large  in  their  apology  for  the  trusts.  And  it  has 
a  sound  basis  in  fact  and  theory.  The  small  business  has  not 
at  its  command  the  capital,  the  organization,  the  flexibility  of 
production,  even  the  intellectual  grasp  of  commercial  affairs, 
to  enable  it  to  enter  successfully  the  field  of  foreign  trade.  It 
is  urged,  therefore,  that  public  policy,  which  requires  that 
foreign  commerce  shall  thrive  under  the  best  auspices,  should 
countenance  the  large  industrial  consolidations.  Some  even 
advocated  that  the  Sherman  Act  should  be  repealed  or  at  best 


XVIII]     EXPANSION  IN  MANUFACTURING  CONCERNS  219 

modified,  so  as  to  legalize  industrial  consolidations  engaged  in 
foreign  trade.  By  no  other  means,  they  believed,  could  Ameri- 
can export  trade  be  developed.  The  Webb  bill  was  the  com- 
promise between  those  who  would  encourage  consolidations 
in  order  to  promote  foreign  trade  and  those  who  would  pro- 
hibit them  in  order  to  prevent  monopoly  in  domestic  trade. 

The  Webb  Act  provides  that  American  export  business  be 
liberated  from  the  restrictions  of  the  Sherman  Act  of  1890. 
It  enables  manufacturers  to  combine  for  the  purpose  of  carry- 
ing on  foreign  trade,  even  though  such  combinations  are 
specifically  prohibited  by  the  Sherman  Act.  Under  the  Webb 
bill  domestic  competitors  may  collectively  form  an  export  cor- 
poration which  markets  a  certain  proportion  of  the  output 
of  all  the  competitors,  each  one  of  which  assigns  to  the  export 
company  a  stated  percentage  of  its  production.  The  act  pre- 
sumes that  manufacturers  can  be  associated  in  their  foreign 
business  and  yet  remain  competitors  in  their  domestic  business. 
It  requires  a  kind  of  trade  duplicity.  Part  of  this  duplicity 
is  a  pure  fiction  and  part  is  based  on  sound  economic  principles. 
In  so  far  as  the  Webb  bill  presumes  that  foreign  business  can 
be  carried  on  without  affecting  domestic  business,  it  is  an 
anomaly;  but  so  far  as  it  presumes  that  foreign  business 
requires  the  continued  support  of  a  large  producing  organiza- 
tion, it  is  absolutely  sound.  In  this  it  is  merely  copying  what 
European  nations  have  already  done  in  building  up  their 
foreign  commerce.  And  without  this  support  our  rapidly 
expanding  foreign  trade  would  be  stifled  by  the  very  anxiety 
of  the  small  producers  to  preserve  their  existence  at  least  under 
the  necessarily  competitive  conditions  of  the  domestic  market. 
In  other  words,  some  kind  of  organized  and  united  effort  must 
take  place  in  order  to  enable  American  manufacturers  to  export 
their  merchandise  in  competition  with  the  organized  and  united 
efforts  of  European  exporting  organizations.  But  whether 
the  problem  is  to  be  solved  by  combinations  among  export 


220  CORPORATION  FINANCE  [  XVIIl 

houses  themselves,  which  carry  many  hnes  into  a  few  highly 
developed  markets,  or  by  combinations  of  manufacturers  carry- 
ing a  single  product  into  many  markets,  only  the  future  devel- 
opments of  commerce  can  tell. 


CHAPTER  XIX 

RAILROAD  EXPANSION 

Present  Conditions. — A  study  of  the  expansion  and  con- 
solidation of  American  railways  is  now  a  matter  of  little  more 
than  historical  importance.  While  there  are  likely  to  be  many 
changes  in  the  corporate  and  financial  organization  of  the 
railways,  still  the  changes  will  inevitably  follow  lines  different 
from  those  during  the  long  period  between  the  commence- 
ment of  railway  consolidation  in  the  early  forties  and  the 
assumption  of  federal  control  on  January  i,  1918.  The  pass- 
ing of  the  Railroad  Act  of  1920,  by  which  the  private  operation 
of  the  carriers  was  resumed,  has  given  the  government  a 
direct  and  explicit  supervision  over  changes  in  operating  and 
financial  control.  The  welfare  of  each  road  is  now  completely 
conditioned  and  circumscribed  by  theories  of  general  public 
expediency.  The  period  of  promotion  and  personal  direction, 
during  which  the  railway  net  was  built,  ended  at  the  opening 
of  the  Great  War;  and  with  it  ended,  too,  the  expansion  and 
consolidation  of  railway  properties  in  the  sense  that  these 
terms  could  be  made  to  apply  to  the  railroad  history  of  previous 
years. 

Forms  and  Devices  of  Consolidation. — Railway  consolida- 
tion in  the  broad  but  restricted  manner  in  which  the  term 
is  used  here  implies  the  direct  merger  of  financial  and 
operating  control.  It  is  brought  about  by  either  lease  or  direct 
ownership,  or  both.  And  direct  ownership  may  be  either 
through  the  ownership  of  stock  or  the  complete  merger  of 
real  and  personal  property  with  the  total  extinction  of  the 
separate  existence  of  one  or  more  corporations.     These  are 


222  CORPORATION  FINANCE  [XIX 

types.  A  great  many  cases  exist  in  which  consolidations  are 
efifected  by  both  lease  and  merger.  And  the  particular  forms 
of  these  fundamental  types  are  as  various  as  the  ingenuity 
of  man  can  invent. 

The  application  of  these  forms  and  devices  by  which  rail- 
road consolidation  and  expansion  has  occurred  will  become 
clear  from  a  summary  statement  of  railroad  consolidation  in 
the  United  States.  This  is  a  subject  of  great  significance  to 
American  corporation  finance,  because  many  of  the  expedients 
employed  in  the  consolidation  of  other  industrial  units  arose 
in  response  to  a  social  demand  which  required  operating — 
and  incidentally  financial — unity  among  railroads. 

Periods  of  Consolidation. — The  history  of  railroad  con- 
solidation in  the  United  States  may  be  roughly  divided  into 
three  periods  of  unequal  length,  according  to  the  extent  and 
the  character  of  the  prominent  railway  consolidations  of  the 
period.  Down  to  the  early  fifties  railroads  were  built  as  small, 
separate,  distinctly  local  enterprises.  Prior  to  that  time  a 
railway  journey  was  made  up  of  various  small  journeys  over 
connecting  lines.  For  example,  in  1852,  before  the  longitudinal 
consolidation  of  railroads  had  begun,  a  passenger  traveling 
along  the  great  north-south  artery  of  travel  would  use  18  differ- 
ent roads  between  Augusta,  Maine,  on  the  north,  and  Mont- 
gomery, Georgia,  on  the  south.  Railroad  consolidation,  in  the 
broad  sense  in  which  the  term  is  used  in  the  present  chapter, 
did  not  occur  until  1853,  when  the  New  York  Central  Rail- 
road was  formed.  From  then  until  the  depression  following 
the  panic  of  1873,  small  local  railroads  all  over  the  East  and 
Middle  West  were  jointed  together  longitudinally  to  form 
through  lines  between  large  cities.  A  second  period  of  rail- 
way consolidation  began  in  the  later  seventies  when  these 
through  lines  were  connected  with  each  other  and  with  lateral 
branches,  to  form  railway  systems.    Just  before  and  following 


XIX]  RAILROAD  EXPANSION  223 

the  many  railway  reorganizations  of  the  middle  nineties,  a 
third  period  of  consolidation  set  in  during  which  the  widely 
articulated  systems  created  during  the  previous  period  were 
still  further  unified  into  great,  loosely  organized  railroad  com- 
binations.   They  became,  as  it  were,  systems  of  systems. 

I.  End-to-End  Consolidations  (1853-1873). — During  the 
first  period  of  consolidation,  roughly  from  1853  down  to 
1873,  small,  local  end-to-end  roads  were  brought  under  a 
single  operating  and  financial  organization.  The  purpose 
invariably  was  to  establish  better  connection  between  two  large 
cities  rather  than  to  develop  railway  systems.  The  first,  and 
for  a  time  the  most  important,  of  these  end-to-end  consolida- 
tions was  that  of  the  five  connecting  roads  constituting  a 
through  line  from  Albany  to  Buffalo.  These  five  roads,  with 
various  lateral  and  parallel  branches,  were  united  in  the  sum- 
mer of  1853  to  form  the  New  York  Central  Railroad.  Three 
years  later  this  end-to-end  consolidation  showed  itself  in  the 
West  in  the  formation  of  the  Chicago,  Burlington  and  Quincy 
by  the  union  of  the  Chicago  and  Aurora  and  the  Central 
Military  Track  Railroad.  In  New  England  end-to-end  con- 
solidation by  lease  appeared  when  in  1861  the  old  Concord 
Railroad  and  the  Manchester  and  Lawrence  agreed  to  the 
joint  operation  of  their  roads  together  with  the  lease  by  the 
former  of  the  Portsmouth  and  Concord  Railroad  and  the 
Manchester  and  North  Weare  Railroad.  By  1873  there  were 
no  less  than  69  of  such  end-to-end  consolidations  of  more 
than  200  miles  in  length.  The  average  length  of  all  these 
69  consolidations  was  only  389  miles  and  the  longest,  the  Erie, 
was  only  959  miles.  In  some  cases  they  represented  mere  end- 
to-end  consolidations  without  the  construction  of  new  mileage, 
except  incidentally.  But  in  the  majority  of  cases  the  con- 
solidation represented  the  bringing  into  a  single  line  completed 
small  railroads  and  others  partially  completed  but  embarrassed 


224  CORPORATION  FINANCE  I XIX 

for  want  of  money  to  continue  construction  The  new  com- 
pany in  such  cases  secured  its  charter  for  the  express  purpose 
of  completing  the  unfinished  sections  of  road  and  building 
other  sections  beyond.  The  methods  and  purposes  were  almost 
as  varied  as  the  consolidations.  It  was  a  question  in  every 
case  of  local  expediency.  Yet  behind  this  variety  it  is  im- 
portant to  observe  that  the  chief  characteristic  of  consolida- 
tions throughout  this  period  down  to  the  panic  of  1873  was 
the  obvious  purpose  of  establishing  longitudinal  through  lines. 
Branch  lines  were  absorbed  and  even  built  but  these  were  in- 
cidental to  the  main  purpose  of  establishing  through  lines  of 
communication.  Railroad  strategy  and  competition  for  ter- 
ritory were  unimportant  factors  in  shaping  the  course  of 
consolidation.  Questions  of  the  gauge  of  the  connecting  lines 
played  a  part  in  shaping  some  consolidations ;  in  others  matters 
of  local  pride  played  no  small  part.  But  the  paramount  ques- 
tion throughout  the  period  was  the  simple  one  of  getting 
through  continuous  service  between  the  large  cities  of  the 
Union. 

2.  Formation    of    Railroad    Systems     (1873-1893). — The 

second  period,  following  the  panic  of  1873,  centered  about  the 
formation  of  railway  systems.  It  is  perhaps  impossible  to  draw 
a  distinct  line  between  the  two;  and  the  distinction  between 
a  through  line  and  a  railway  system  is  arbitrary  indeed.  Nor 
did  the  change  of  emphasis  occur  simultaneously  in  all  parts 
of  the  country,  so  that  the  historical  divisions  we  are  insisting 
on  here  are  admittedly  crude  and  arbitrary.  But  it  is  an 
historical  fact  that  prior  to  the  panic  of  1873  little  effort  was 
expended  in  developing  unified,  self-dependent,  well-rounded 
railway  systems,  whereas  in  the  years  following  the  awaken- 
ing of  business  in  the  late  seventies  this  was  the  center  of 
interest  among  railway  operators.  Their  vision  had  become 
enlarged. 


XIX  J  RAILROAD  EXPANSION  225 

Improved  Methods  of  Operating. — Aside  from  the  natural 
desire  of  railroad-owners  and  officials  to  expand  their  prop- 
erties, several  facts  connected  with  the  physical  operation  of 
railroads  tended  to  promote  the  amalgamation  of  railways 
into  systems.  Perhaps  the  most  prominent  of  these  was  the 
acceptance  of  a  uniform  gauge  for  all  the  railroads  of  the 
country.  In  1865  there  was  no  uniformity  of  gauge  and 
great  inconvenience  and  expense  was  involved  in  the  trans- 
shipment of  freight  at  connecting  points  between  railroads 
having  different  gauges.  By  1875  most  of  the  roads  of  the 
Northeast  and  West  had  adopted  the  standard  gauge  and  the 
important  roads  having  a  wider  gauge  had  laid  a  third  or  fourth 
rail  to  accommodate  the  interchange  of  rolling  stock.  By 
1886  the  roads  of  the  entire  country  had  adopted  the  standard 
gauge  and  a  loaded  freight  car  could  move  freely  over  the 
whole  national  system  of  railroads.  In  addition  to  the  es- 
tablishment of  a  uniform  gauge  throughout  the  country  there 
had  gradually  developed  a  great  number  of  technical  im- 
provements in  the  rolling  stock,  the  road  bed,  and  the  signaling 
systems.  Radical  improvements  along  these  lines  were  most 
conspicuous  in  the  decade  following  the  Civil  War.  The 
result  in  every  case  was  to  improve  the  quickness,  certainty, 
ease,  and  cheapness  of  movement  of  trains.  And  in  response 
to  the  greater  rapidity  and  safety  of  transportation  the  public 
came  to  demand  an  improved  service.  One  of  the  chief  req- 
uisites of  this  improved  service  was  fast  through  trains, 
both  passenger  and  freight.  This  demanded  extensive 
organization  wliich  easily  tended  to  promote  the  development 
of  the  railroad  system. 

Competition. — Coincident  with  the  growth  of  improved 
methods  of  operation  went  the  growth  of  competition.  As 
small  railroads  were  joined  longitudinally  so  as  to  form 
through  routes  between  large  cities,   competition  over  these 


226  CORPORATION  FINANCE  [XIX 

routes  began  to  develop.  Soon  after  a  through  route  from 
the  Great  Lakes  to  New  York  had  been  estabhshed  by  way  of 
the  New  York  Central  to  Albany  and  the  Hudson  River  road 
to  the  Harlem,  the  Erie  and  its  connections  also  began  to 
ofifer  a  corresponding  service.  No  sooner  had  one  series  of 
roads  established  a  connection  between  two  important  points 
than  some  other  routes  began  to  compete  with  it  for  the 
meager  traffic  available.  Competition  loomed  large  as  a 
factor  in  railroad  operation  and  railroad  management. 
Inevitably,  whatever  the  field  of  industry,  consolidation  is 
sought  as  a  remedy  for  competition.  And  this  unquestionably 
was  one  of  the  underlying  causes  that  led  to  the  development 
of  railway  systems  in  the  period  after  the  panic  of  1873. 

The  Impulse  to  Expand. — But  more  important  by  far 
than  any  advances  in  the  technical  or  administrative  operation 
of  the  railroads  and  the  rivalry  engendered  by  competition, 
was  the  growing  strength  among  prominent  business  executives 
of  the  impulse  to  expand.  The  crude  beginnings  of  railway 
systems  were  to  be  found  before  1873.  But,  like  the  early 
development  of  the  Pennsylvania  system,  they  were  the  result 
of  the  force  of  pressure  from  without  rather  than  from  within. 
After  the  depression  following  the  panic  of  1873  the  whole 
motive  changed.  A  new  force,  psychological  rather  than 
technical  or  economic  in  character,  had  injected  its  virus 
into  the  railroad  world.  Just  as  some  fifteen  or  twenty  years 
later  the  development  of  internal  commerce  made  it  appear 
possible  to  combine  the  operation  of  geographically  separated 
factories  under  a  single  management,  so  the  creative  imagina- 
tion of  the  railroad  operators  grasped  at  the  possibility  of 
combining  through  routes  and  branch  lines  into  closely  knit 
railway  systems.  The  natural  instinct  of  the  business  ex- 
ecutive is  to  play  for  bigger  things.  This  is  his  mode  of 
exercising  the  primal  Anglo-Saxon  craving  for  conquest.    This 


XIX]  RAILROAD  EXPANSION  227 

simple  explanation  is  all  that  is  necessary  to  explain  why,  dur 
ing  the  ten  or  fifteen  years  of  business  expansion  between  the 
panics  of  1873  and  1893,  a  large  number  of  the  great  railway 
systems  of  the  country  were  created  out  of  disjointed  parts. 

Plan  of  Physical  Development. — The  methods  employed  in 
building  up  a  railroad  system  varied  in  individual  cases.  But 
a  general  plan  of  physical  development  has  been  sufficiently 
common  among  important  railway  systems  to  be  considered 
typical.  In  brief,  it  has  consisted  of  the  extension,  longitudi- 
nally and  laterally,  of  a  single  relatively  short  trunk  line.  This 
extension  was  usually  effected  both  by  consolidation  with 
previously  existent  lines  and  by  the  construction  of  new  lines 
and  new  connecting  links.  A  single  line,  oftentimes  only  a 
few  miles  in  length  and  of  relative  insignificance,  became 
dominated  by  men  who  were  moved  by  the  impulse  for  expan- 
sion. The  line  was  then  extended  longitudinally  and  laterally. 
It  seemed  to  move  forward,  like  a  primitive  amoeba,  by  the 
extension  of  lateral  processes  in  directions.  It  acquired  a 
significance  in  the  railway  world  quite  disproportionate  to  its 
size.  It  became,  in  effect,  the  nucleus  of  a  railway  system. 
The  development  of  the  Atchison,  Topeka  and  Santa  Fe  rail 
system  is  an  illustration  of  the  principles  at  play,  though  no 
more  typical  than  is  the  development  of  other  large  railway 
systems.  Finished  as  a  completed  road  of  471  miles  in  1873, 
it  grew  rapidly  until  in  1892 — less  than  twenty  years — it  be- 
came a  railway  system  of  over  9,000  miles  in  length.  And  the 
growth  of  railway  systems  similar  to  the  growth  of  the 
Atchison,  but  not  quite  so  extreme,  was  taking  place  all  over 
the  United  States.  In  1873  there  were  no  railroads  in  the 
country  more  than  1,200  miles  in  length,  including  the  branch 
lines,  and  only  three  in  excess  of  900  miles.  In  1893  there 
were  35  systems  possessing  a  mileage  in  excess  of  1,000  miles 
and  5  separate  systems  that  exceeded  5,000  miles. 


228  CORPORATION  FINANCE  [XIX 

3,  Formation  of  Systems  of  Systems   (1893-1910) But 

the  development  of  railway  systems  was  not  enough.  In  the 
late  eighties,  about  the  time  the  formation  of  industrial  trusts 
began  to  attract  seriously  the  attention  of  business  men  and 
political  and  social  observers,  railway  operators  began  to 
enlarge  their  spheres  of  influence  from  railway  systems  to 
systems  of  systems.  Thus  began  the  third  and  last  period  of 
railway  consolidation.  In  the  earlier  periods  combination  was 
usually  dominated  by  traffic  expediency.  It  was  the  hope  of 
holding  and  increasing  traffic  that  led  to  the  end-to-end  unions 
of  the  early  period  and  to  the  welding  of  disconnected  lines  into 
systems  in  the  second  period.  But  in  this  third  period  of 
consolidation  the  ruling  motive  was  not  so  much  the  increasing 
of  traffic,  for  that  could  be  obtained  by  intensive  development 
of  the  already  existent  systems,  but  the  increasing  of  adminis- 
trative and  financial  control  over  whole  sections  of  territory. 
Instead  of  consistency  and  inward  coherence  a  myotic,  head- 
strong, and  unreflective  competition  for  power  dominated  rail- 
road strategy.  As  a  result,  railroad  systems  were  joined  to- 
gether, often  by  mere  accident,  provided  the  power  of  the  rail- 
road operators  was  increased  and  the  scope  of  their  activities 
extended. 

The  process  continued,  uninterruptedly  until  the  Northern 
Securities  decision  of  the  Supreme  Court  forced  a  reversion, 
or  perhaps  slowing  down  of  the  consolidation  mania.  Then, 
following  the  panic  of  1907  and  the  railroad  legislation  of 
191  o,  the  railroad  operators  began  to  question  the  expediency 
of  burdening  the  already  extended  railroad  systems  by  still 
further  extensions.  Railroad  consolidations  ceased  altogether. 
And  in  the  reorganizations  occurring  between  191 3  and  19 18 
there  was  a  reversion  of  the  process  and  large  parts  of  the  bank- 
rupt railroads  were  lopped  ofif.  The  problems  of  efficient  rail- 
road management  were  serious  enough  with  a  small  system; 
they  became  well-nigh  insurmountable  with  a  great  disjointed 


XIX]  RAILROAD  EXPANSION  229 

and  inarticulate  system  when  the  general  structure  gave  no 
especial  ground  for  expecting  increased  economy  of  manage- 
ment. Railroad  consolidation  was  discredited  by  actual  ex- 
perience quite  as  much  as  by  the  Supreme  Court. 

Methods  of  Consolidation — i.  Consolidation  by  Lease. — 

During  this  long  period  of  railroad  consolidation  two  general 
methods  were  pursued,  (i)  consolidation  by  lease,  and  (2) 
consolidation  by  merger.  Consolidation  by  means  of  the  lease 
of  one  railroad  property  by  another  secures  the  benefits  of 
united  operation  without  the  financial  cost  involved  in  the 
outright  purchase  of  a  railroad  property  or  even  of  the  con- 
trolling shares  in  a  railroad  property.  This  is  the  chief 
advantage  of  the  lease.  The  feature  of  importance  in  all  lease 
agreements  is  the  compensation.  This  is  either  fixed  or  con- 
tingent. In  the  fixed-rental  leases  one  railroad  corporation 
agrees  to  pay  to  another  railroad  corporation  or  to  its  security- 
holders a  stipulated  annual  amount ;  in  the  contingent-rental 
leases  the  annual  payments  depend  on  some  variable  element, 
such  as  earnings  or  the  volume  of  interchanged  trafific. 

Contingent  Rentals. — It  is  distinctly  an  open  question  as 
to  what  form  of  contingent  rental  is  fairest  to  all  concerned.  A 
rental,  which  is  ultimately  a  contract  between  the  security- 
holders of  the  two  corporations,  must  obviously  involve 
advantages  to  both.  Usually  the  most  important  advantage 
is  in  the  exchange  of  traffic.  This  is  registered  in  the  volume 
of  gross  business,  so  that  a  proportion  of  gross  earnings  would 
seem  at  first  thought  to  be  the  fairest  basis  for  determining 
the  rental.  And  this  would  be  true  were  the  earnings  of  the 
subsidiary  not  affected  by  the  joint  traffic  agreement  between 
the  two  roads.  But  when  the  main  line  is  able,  through  the 
control  of  a  majority  of  the  stock  of  the  subsidiary,  to  impose 
on  the  latter  an  agreement  on  interchanged  traffic  which  returns 


230  CORPORATION  FINANCE  [XIX 

to  the  subsidiary  an  unconscionably  small  percentage  of  the 
joint  revenue,  the  earnings  remaining  to  the  subsidiary's  own 
security-holders  will  be  meager  and  unfairly  small.  If  all 
the  securities  of  a  leased  line  are  owned  by  a  parent  company, 
or  at  the  other  extreme  if  the  larger  company  has  little  owner- 
ship in  the  subsidiary  or  cannot  exercise  any  control  over  the 
traffic  interchange  contract,  then  there  can  be  complete  free- 
dom of  contract  between  the  two  boards  of  directors  and  no 
unfairness  of  rental  can  be  alleged.  But  in  cases  like  those 
enumerated  above,  when  there  is  a  conflict  of  interest  between 
a  controlling  majority  and  a  helpless  minority  of  security- 
holders, a  question  not  only  of  the  expediency  but  also  the 
fairness  of  leased  line  rentals  is  inevitably  raised.  And  this 
difficulty  is  increased  when  the  rental  is  based  on  net  rather 
than  gross  earnings.  For  in  such  cases  the  controlling  parent 
company  may  not  only  determine  the  division  of  the  revenue 
from  the  interchange  of  traffic,  but  it  may  also  control  the 
expenditures  for  operating  expenses  of  the  subsidiary,  so  as 
to  fix  arbitrarily  its  net  earnings  and  its  rental. 

These  difficulties  proved  to  be  serious  obstacles  in  the  build- 
ing of  railway  systems.  The  contingent  rental  must  be  fair, 
and  not  open  to  the  accusation  of  secret  manipulations.  Yet 
at  the  same  time  it  should  give  the  leasing  road  the  benefits 
of  its  abler  and  more  highly  organized  operation.  The  latter 
would  not  assume  the  responsibility  of  the  lease  without  the 
benefits  which  would  be  likely  to  increase  through  the  years. 
For  these  reasons  fixed  rentals  have  been  preferred  over  any 
form  of  contingent  rental  and  their  use,  as  compared  with 
contingent  rentals  in  any  form,  has  increased  during  each 
succeeding  period  of  railroad  consolidation.  At  the  time  of 
government  control,  they  were  the  important  form  of  lease. 

Fixed  Rentals. — The  differences  in  rental  payments  are 
not  as  important  as  would  appear  at  first  sight.     In  most  cases 


XIX]  RAILROAD  EXPANSION  23 1 

there  was  outstanding  at  the  time  the  lease  was  originally 
written  many  years  ago,  considerable  amounts  of  stocks  and 
of  bonds  in  the  hands  of  the  public.  In  the  majority — but  by 
no  means  all — of  the  leases  of  this  character,  the  parent  road 
has  gradually  acquired  the  stocks  and  often  the  bonds  of  the 
leased  road,  so  that  the  payment  of  the  fixed  rental  is  merely 
a  bookkeeping  adjustment  involving  the  transfer  of  credits 
from  one  account  to  another.  When  considering  the  lease, 
indeed,  merely  as  a  device  for  consolidating  railway  lines,  the 
fixed  rentals  are  significant  only  in  the  smaller  number  of 
cases  in  which  the  leased-line  securities  are  still  in  the  hands 
of  the  public.  It  is  important,  however,  to  note  that  the 
number  of  such  cases,  especially  among  New  England  lines, 
is  still  sufficiently  numerous  to  present  an  important  and  often 
embarrassing  problem. 

The  device  of  fixed  rentals  with  large  amounts  of  the 
leased  line's  stock  remaining  in  the  hands  of  the  public  has 
great  advantages  to  the  parent  road  during  the  time  that  the 
prosperity  of  the  railroads  is  ascending.  It  then  shuts  out  the 
old  leased  line's  security-holders  from  the  increased  profits 
due  to  greater  prosperity  and  gives  to  the  controlling  manage- 
ment the  full  fruits  of  increased  economy  and  efficiency  of 
operation.  But  just  the  reverse  is  true  when  the  lease  is 
consummated  before  or  during  a  period  of  declining  pros- 
perity. In  that  case  the  security-holders  of  the  leased  road 
may  demand  their  rental  whether  or  not  it  has  been  earned. 
The  chafge  has  become  fixed  and  inflexible  and  its  default 
would  precipitate  failure  of  the  whole  consolidated  structure. 
And  it  is  unquestionably  true  that  with  the  further  develop- 
ment of  railway  consolidation  under  the  encouragement  of 
the  Cummins  Act  of  1920  rather  than  the  discouraging  pro- 
hibitions of  the  Sherman  Act  of  1890,  the  lease  will  dwindle 
to  insignificance  as  a  means  of  consolidation.  In  forced 
reorganizations,  like  that  of  the  Boston  and  Maine,  it  has  so 


232  CORPORATION  FINANCE  [XIX 

far  as  possible  been  superseded  by  direct  consolidation.  And 
this  change  is  destined  to  occur  in  the  future  in  all  cases  where 
the  fiction  of  a  lease  is  not  required  as  a  legal  subterfuge. 
Nevertheless  it  has  a  great  historical  significance  in  the  develop- 
ment of  American  railway  consolidation. 

2.  Consolidation  by  Merger. — A  lease,  whatsoever  the 
form  of  compensation,  is  a  relatively  weak  and  uncertain 
means  of  effecting  consolidation.  Its  very  economy,  even, 
is  not  always  an  advantage,  for  what  is  cheaply  got  is  often 
easily  lost.  If  the  union  is  very  important  to  the  consolidated 
system,  a  railroad  management  will  not  ordinarily  allow  it  to 
rest  on  a  mere  lease.  The  stockholders  of  the  leased  line  might 
find  some  excuse  for  canceling  the  lease  directly ;  or  they  could 
allow  their  road  to  be  thrown  into  the  hands  of  a  court  receiver 
who  would  then  cancel  the  lease  as  an  undesirable  contract 
inherited  from  the  past  management.  The  leasing  road  would 
be  helpless  in  either  event  to  prevent  the  action  or  even  to 
collect  damages  from  the  receiver  of  the  reorganized  road. 
In  order  to  prevent  any  such' misfortune,  leasing  railroads 
have  always  sought  to  reinforce  the  lease  by  the  purchase  of 
at  least  a  portion  of  the  stock  of  the  leased  road.  This  in- 
troduces at  once  the  second  great  type  of  consolidation  ex- 
pedients, namely,  that  of  stock  control. 

Ever  since  the  consolidation  of  railroads  commenced  it 
has  been  the  policy  of  railroad  managers  to  purchase  at  least 
a  minority  stock  interest  in  the  railroads  the  operation  of 
which  was  important  for  the  main  system.  This  was  true 
even  when  the  subordinate  road  was  controlled  by  lease.  And 
if  the  subordinate  road  is  of  essential  importance,  it  is  probable 
that  those  in  control  of  the  consolidated  system  will  insist  on 
obtaining  sufficient  stock  to  secure  a  majority  stock  control 
in  addition  to  the  lease. 

The  advantage  of  consolidation  through  ownership  of  a 


XIX]  RAILROAD  EXPANSION  233 

portion  of  the  stock  of  a  railroad  rather  than  complete  owner- 
ship, lies  in  the  greater  economy.  Complete  control  is  secured, 
moreover,  if  a  majority  of  the  shares  are  acquired,  so  that 
the  danger  of  the  repudiation  of  the  lease  is  not  present  as  when 
the  road  is  held  by  a  contract  of  lease  alone;  yet  the  invest- 
ment is  small  compared  with  that  required  for  the  outright 
purchase  of  the  road.  Especially  is  this  true  if  the  subsidiary 
road  has  a  considerable  bond  issue  which  would  have  to  be 
paid  off  before  absolute  title  could  be  acquired.  It  is  this 
security  of  control,  combined  with  the  small  money  outlay, 
that  has  made  this  method  of  consolidation  the  usual  one  in 
the  history  of   American   railways. 

All  manners  of  combinations  of  the  lease  and  the  stock 
control  are  to  be  found  in  the  annals  of  American  railway 
consolidation.  And  very  frequently  the  lease  is  employed 
as  a  reinforcement  to  stock  control,  just  as  stock  control  is 
used  to  reinforce  a  lease.  But  in  theory  the  two  methods  are 
distinct.  The  stock  control  involves  the  outright  ownership 
of  sufficient  of  the  voting  stock  to  give  the  main  road  absolute 
executive  management  of  the  subsidiary.  It  selects  the  board 
of  directors.  It  determines  its  policy  with  the  same  autocracy 
as  it  does  its  own  lines.  The  control  is  therefore  permanent 
and  absolute,  so  that  the  directors  of  the  consolidated  system 
may  look  upon  the  subsidiary  road  in  their  plans  about  the 
future  as  if  it  were,  to  all  intents,  their  own  absolute  property. 
For  this  reason  control  through  stock  ownership  permits 
greater  scope  and  comprehensiveness  in  determining  policies 
than  control  merely  through  a  lease. 

Methods  of  Acquiring  Stock  Control — i.  Purchase  of 
Stock. — In  acquiring  stock  control  three  important  methods 
have  been  followed.  The  simplest  is,  of  course,  the  outright 
purchase  of  a  railroad's  shares,  either  at  private  sale  or  on  one 
of  the  exchanges.    Ordinarily  a  large  road,  wishing  to  acquire 


234  CORPORATION  FINANCE  [XIX 

Stock  control  of  a  smaller  road,  ascertains  by  Inquiry  the  names 
of  the  road's  largest  stockholders.  Its  representatives  then  make 
overtures  looking  toward  the  outright  purchase  of  a  sufficient 
number  of  shares  to  give  it  control.  When  the  stock  of  a  small 
line  is  v^^idely  held,  or  when  two  railroads  are  seeking  to 
acquire  its  control,  it  may  be  necessary  to  go  to  extreme  lengths 
in  picking  up  the  stock.  Instances  have  been  known  of  the 
agents  for  the  purchasing  railroad  going  from  house  to  house 
among  the  stockholders  in  order  quickly  to  secure  a  majority  of 
the  shares.  Having  arranged  for  the  purchase  of  a  large  or 
majority  interest  from  a  few  of  the  most  important  stock- 
holders, the  road  then  announces  publicly  that  it  will  purchase 
all  the  stock  offered  to  it  at  a  specific  price,  reserving  to  itself 
the  right  to  withdraw  the  offer  at  any  time.  The  road  is  thus 
enabled  to  retire  from  the  market  as  soon  as  it  has  acquired  the 
requisite  control,  or  it  may  continue  to  purchase  all  the  shares 
offered  in  the  hope  of  obtaining  not  only  a  majority  of  the 
shares  but  also  the  entire  capital  stock.  In  the  latter  case 
it  becomes  relieved,  forever,  from  the  fear  of  any  legal  inter- 
ference or  obstructions  arising  from  a  small  but  recalcitrant 
minority. 

2.  Exchange  of  Stock. — Another  method  of  obtaining  stock 
control  at  the  time  of  railway  consolidation  is  through  an  ex- 
change of  stock.  This  method  was  very  common  in  the  period 
during  which  the  large  railway  systems  were  being  built  up — 
down  to  the  panic  of  1893.  In  fact  some  very  important  rail- 
way systems  came  into  existence  originally  through  an  extensive 
exchange  of  the  stocks  of  numerous  small  lines  for  the  stock  of 
a  new  company  formed  for  the  very  purpose.  This  was  the 
origin  of  the  New  York  Central.  This  method  of  consolidating 
by  an  exchange  of  stocks  has  the  advantage  over  outright 
purchase  in  requiring  no  direct  money  expenditure,  so  that  no 
financial  expedients  have  to  be  adopted  in  order  to  obtain 


XIX]  RAILROAD  EXPANSION  235 

money.  On  the  other  hand,  it  was  usually  necessary  for  the 
road  that  acquired  the  stock  of  another  through  exchange  of 
its  own  shares  to  make  a  particularly  favorable  offer  to  the 
shareholders  of  the  other  road  in  order  to  tempt  them  to 
surrender  control  of  their  property.  This  is  expensive,  when 
viewed  as  a  dilution  in  the  value  of  the  purchasing  road's  own 
stock.  On  the  other  hand,  very  often  the  advantage  of  securing 
a  stock  of  greater  marketability  is  quite  as  effective  in  leading 
the  shareholders  of  a  small  local  road  to  exchange  their  stock 
for  that  of  a  large  road  at  an  apparent  profit ;  in  some  cases 
the  prosperity  of  the  small  road  is  so  closely  connected  with 
that  of  the  large  road  that  the  shareholders  feel  that  their 
investment  is  best  protected  when  made  an  integral  part  of 
the  consolidated  system. 

3.  Use  of  Collateral  Trust  Bonds. — There  have  been  many 
instances  during  the  thirty  years  from  1880  to  1910  in  which 
a  third  method  has  been  adopted,  the  use  of  the  collateral  trust 
bond  by  one  railroad  system  to  acquire  stock  control  or  even 
entire  stock  ownership  of  another  railroad.  Three  notable 
examples  require  more  than  mere  passing  comment  because 
of  the  extent  and  importance  of  the  railway  mileage  involved. 
In  1898  the  New  York  Central  and  Hudson  River  Railroad 
found  it  necessary — as  the  Pennsylvania  Railroad  had  found 
it  necessary  thirty  years  before — to  acquire  absolute  control 
and  ownership  of  its  Chicago  extension.  Accordingly,  the 
directors  of  the  New  York  Central  and  Hudson  River  Rail- 
road offered  to  give  to  the  stockholders  of  the  Lake  Shore 
and  Michigan  Southern  Railroad  a  collateral  trust  bond,  $1,000 
in  denomination  and  bearing  3^  per  cent  interest,  in  exchange 
for  two  shares  of  stock.  The  stock  was  deposited  as  collateral 
for  the  bonds.  The  Lake  Shore  stock  had  been  paying  6  per 
cent  dividends  since  1888  and  large  sums  had  been  invested 
in  the  property  out  of  earnings.     The  shareholders  had  an 


836  CORPORATION  FINANCE  [XIX 

apparent  increase  of  income.  At  the  same  time  they  obtained 
in  addition  a  direct  obligation  of  the  New  York  Central 
system  that  ranked  ahead  of  the  large  investment  of  the 
Central's  stockholders,  and  were  well  protected  against  the 
further  issue  of  mortgage  bonds. 

In  1902,  when  the  movement  in  the  direction  of  the  con- 
solidation of  great  railway  systems  reached  its  greatest  scope, 
two  large  issues  of  collateral  trust  bonds  were  used  to  acquire 
control  of  the  stock  of  two  great  railroad  systems — the  Louis- 
ville and  Nashville,  and  the  Chicago,  Burlington  and  Quincy. 
In  the  former  case  the  Atlantic  Coast  Line  acquired  the  ma- 
jority of  the  stock  of  the  Louisville  and  Nashville  Railroad 
as  the  outcome  of  a  speculative  raid.  There  was  apparently 
no  preconceived  plan  on  the  part  of  the  Atlantic  Coast  Line 
to  secure  control  of  the  Louisville  and  Nashville.  Yet  as  a 
result  of  the  efforts  of  a  certain  Wall  Street  gambler  a  ma- 
jority of  its  shares  had  been  brought  together  and  were  offered 
for  sale.  To  place  them  under  the  control  of  the  Atlantic 
Coast  Line  seemed  on  the  whole  the  best  solution  of  the 
difficulty,  and  the  collateral  trust  bonds  of  the  Atlantic  Coast 
Line  were  issued  to  secure  the  necessary  funds. 

The  acquisition  of  the  stock  of  the  Chicago,  Burlington 
and  Quincy  Railroad  by  the  roads  controlled  by  the  late 
James  J.  Hill  was,  on  the  other  hand,  the  result  of  a  pre- 
conceived plan.  Neither  the  Great  Northern  nor  Northern 
Pacific  Railroad  had  an  eastern  terminal  in  Chicago.  This 
was  a  very  serious  handicap  in  the  competition  for  transcon- 
tinental traffic.  Especially  was  this  true  as  the  Union  Pacific 
had  a  closely  affiliated  Chicago  connection  in  the  Chicago  and 
Northwestern  Railroad  and  the  Atchison  reached  Chicago 
over  its  o\Vn  tracks.  Accordingly,  the  directors  of  the  two 
northern  railroads  offered  to  give  to  the  stockholders  of  the 
Chicago,  Burlington  and  Quincy  Railroad — many  of  them 
New  England  investors — $1,000  par  value  in  the  4  per  cent 


XIX  J  RAILROAD  EXPANSION  237 

joint  bonds  of  the  Great  Northern  and  Northern  Pacific  rail- 
roads. These  bonds  were  to  be  secured,  in  addition  to  the 
joint  and  separate  guaranty  of  the  two  railroads,  by  the 
deposit  with  the  trustees  of  the  Burlington  stock.  Practically 
all  the  stockholders  of  the  Burlington  road  accepted  the  ofifer, 
and  without  the  use  of  any  of  their  own  capital  the  two 
Hill  roads  secured  the  absolute  control  of  one  of  the  finest 
railway  systems  in  the  world. 

The  evil  of  the  pyramiding  of  credit  by  the  issue  of  collat- 
eral trust  bonds  occurs  when  the  earnings  of  the  road  whose 
stock  is  acquired  fail  to  permit  a  dividend  sufficient  to  carry  the 
interest  on  the  collateral  trust  bonds.  As  in  the  case  of  the 
fixed  rental,  the  plan  works  very  well  so  long  as  the  earnings 
of  the  newly  acquired  road  equal  or  exceed  the  cost  of  carrying 
it.  But  railway  earnings  fluctuate.  And  the  experience  of 
several  roads  which  have  followed  this  plan  of  consolidation 
has  been  very  unfortunate.  In  fact  the  receivership  of  the 
Toledo,  St.  Louis  and  Western  Railroad  in  1914  was  due 
to  this  cause  and  this  cause  alone.  In  other  receiverships 
it  has  beeii  an  important  contributing  cause.  Nevertheless 
the  collateral  trust  bond  has  been  and  is  still  used  as  the 
simplest  and  distinctly  the  cheapest  means  of  pyramiding  rail- 
road properties. 

4.  Outright  Purchase  of  Roads. — The  fourth  general 
method  of  consolidating  railroads  is  by  complete  outright  pur- 
chase. It  is  the  most  expensive  method,  requiring  a  large 
outlay,  but  it  results  in  the  most  complete  and  permanent 
union  possible  among  railroads.  Sufficient  money  must  be  ad- 
vanced by  the  purchasing  road  to  pay  for  the  outstanding 
stocks  of  the  road  to  be  acquired  and  in  addition  sufficient 
to  meet  all  its  outstanding  liabilities.  Because  of  this  heavy 
outlay  of  capital,  the  outright  purchase  of  one  road  by  another 
is  resorted  to  ordinarily  only  if  the  road  is  small,  so  that  the 


238  CORPORATION  FINANCE  [XIX 

actual  money  outlay  is  relatively  insignificant,  or  else  if  it  is 
possible  to  arrange  a  direct  transfer  of  liabilities, 

A  purchasing  road  may,  for  instance,  be  able  to  command 
enough  money  to  buy  the  entire  outstanding  stock  of  the 
road  it  desires  to  control,  and  to  pay  off  all  the  debts  of  the 
road  except  a  single  issue  of  bonds.  The  first  road  will  then 
acquire  title  to  and  complete  ownership  of  the  second  road 
subject  to  the  single  remaining  bond  issue.  In  technical 
language,  the  bonds  remaining  outstanding  are  "assumed"  by 
the  purchasing  road.  This  explicit  assumption  of  the  bonds 
of  a  small  line  has,  at  times,  been  the  only  price  a  large  and 
established  railroad  has  been  required  to  pay  for  the  acquisition 
of  a  small  line.  The  Washington  County  Railroad  of  Maine, 
for  instance,  completed  in  1899  through  the  efforts  of  Grant 
B,  Schley,  a  prominent  New  York  banker,  failed  to  meet  operat- 
ing expenses.  In  1903  the  proprietors  consented  to  refund  their 
issue  of  over  $2,000,000  of  5  per  cent  50-year  bonds,  due  in 
1948  and  representing  the  construction  costs  of  the  railroad, 
into  3^  per  cent  bonds  due  in  1954;  and  agreed  to  surrender 
to  the  Maine  Central  Railroad  their  entire  stock  interest  in 
return  for  the  guaranty  by  the  Maine  Central  Railroad  of 
interest  and  principal  on  the  new  bonds. 


CHAPTER  XX 

THE  PUBLIC  UTILITY  HOLDING  COMPANY 

Control  over  Many  Small  Companies. — One  of  the  most 
remarkable  illustrations  of  corporate  consolidation  with  some 
degree  of  individualization  of  parts  is  represented  by  the  public 
utility  holding  company.  This  financial  device  represents  a 
means  which  gives  concentrated  financial  and  operating  control 
over  small  independent  public  utilities,  widely  separated 
geographically. 

In  the  simplest  form  the  public  utility  holding  company 
consists  of  a  corporation  organized  under  the  laws  of  some 
state,  which  permits  its  corporations  to  hold  the  securities  of 
other  corporations  in  its  treasury.  It  acquires  at  least  a 
majority  of  the  stock  of  local  gas,  electric,  and  traction  com- 
panies. Against  these  treasury  securities  it  issues  its  own 
stocks  and  bonds.  In  brief,  the  holding  company  acquires  a 
control  of  the  equities  of  local  utilities,  and  through  the  owner- 
ship of  these  equities  exerts  a  direct  administrative  control 
over  the  operation  of  the  local  utilities  themselves — it  is  a 
kind  of  industrial  combination  applied  to  the  field  of  local  public 
service  companies. 

The  United  Gas  Improvement  Company  was  the  first  suc- 
cessful holding  company  of  this  kind.  It  has  acquired  the  con- 
trol and  ownership  of  gas,  and  later  electric  light,  plants  in  all 
parts  of  the  United  States.  These  are  operated  by  34  sub- 
sidiaries, having  a  combined  capitalization  of  $200,000,000,  in 
addition  to  the  $60,000,000  of  common  and  $6,000,000  pre- 
ferred share  capital  of  the  United  Gas  Improvement  Company 
itself.  Its  income  has  steadily  increased  and  since  1889  the 
company  has  paid  regular  dividends  of  8  per  cent.     In  1918 

239 


240  CORPORATION  FINANCE  [XX 

its  accumulated  surplus  amounted  to  over  $35,000,000.  Since 
then,  owing  to  unwarranted  expansions  of  certain  of  its  sub- 
sidiaries, the  financial  responsibility  of  which  fell  back  upon 
the  shoulders  of  the  holding  company,  the  United  Gas  Improve- 
ment Company  has  lost  ground  relatively  and  absolutely. 

Its  early  success  attracted  imitators  but  in  many  cases  the 
covert  purpose  of  these  imitators  seems  to  have  been  to  secure 
a  promotion  profit  rather  than  a  profit  through  economies  and 
efficiencies  in  the  operation  of  the  local  utilities,  and  in  conse- 
quence these  later  holding  companies  have  seldom  proved  con- 
spicuously successful. 

In  a  given  instance  it  is  sometimes  difficult  to  distinguish 
between  the  small  holding  company  and  the  large  operating 
company,  especially  when  all  the  municipalities  serv^ed  are  in 
the  same  locality  but  the  operating  plants  are  physically  dis- 
tinct from  each  other.  And  any  attempt  to  draw  an  arbitrary 
distinction  between  the  two  must  end  in  confusion,  for  in 
actual  experience  there  are  countless  combinations.  Yet  the 
cases  to  which  special  reference  is  made  in  this  chapter  are 
those  which  are  the  holding  companies  of  many  individual 
operating  companies  distinct  from  each  other  in  organization, 
management,  and  financial  structure. 

Advantages  of  the   Public   Utility   Holding   Company. — 

The  advantages  of  the  public  utility  holding  company  over  the 
independently  owned  and  operated  local  utility  have  often  been 
reviewed.  Nowhere  have  these  advantages  been  more  clearly 
expressed  than  in  a  certain  brief  filed  May  11,  1914,  with  the 
Interstate  Commerce  Commission  of  the  United  States  Senate 
with  reference  to  Senate  Bill  No.  4160: 

The  holding  company  unites  under  one  control  and  manage- 
ment the  public  utilities  of  several  communities.  The  increased 
volume  of  business  so  obtained  enables  the  holding  company  to 
make  the  expenditure  necessary  to  secure  a  thoroughly  com- 


XX]  THE  PUBLIC  UTILITY  HOLDING  COMPANY  241 

petent  executive,  engineering,  and  operating  staff,  whose  services 
are  available  to  all  of  its  subsidiaries.  Thus,  along  with  the 
resulting  increase  in  efficiency,  the  expenses  of  each  subsidiary 
are  materially  reduced.  Expenses  are  further  reduced  by  the 
standardization  of  materials  and  supplies,  and  by  the  purchasing 
of  such  supplies  by  skilled  purchasing  agents  in  large  quantities 
in  a  far  wider  market  and  upon  much  better  terms  of  credit 
than  could  possibly  be  secured  by  the  separate  local  companies 
acting  independently.  The  centralized  expert  management 
effects  further  economies  in  the  cost  of  production  by  the 
standardization  of  operating  and  accounting  methods.  Plants 
are  combined  and  construction  work  is  standardized,  so  that 
equipment  outgrown  by  one  community  can  be  utilized  by  trans- 
fer to  another  smaller  community,  instead  of  being  discarded 
as  useless ;  in  this  way  the  enterprise  is  run  with  a  minimum 
amount  of  capital,  and  depreciation  charges  are  materially 
lessened.  The  distribution  of  the  business  over  an  enlarged 
territory  "averages  the  risk"  and  secures  the  holding  company 
against  irreparable  damage  from  purely  local  causes.  All  of 
these  improved  conditions  operate  to  increase  the  attractiveness 
of  the  enterprise  to  the  investor,  and,  consequently,  to  bring 
about  the  very  great  economy  of  decreased  cost  of  capital  and 
the  resultant  fixed  carrying  charges. 

In  addition  to  these  general  advantages  the  small  com- 
ponent of  a  large  holding  company  has  certain  distinct  advan- 
tages in  the  sales  of  its  service.  This  sale  must  be  made  with 
foresight  and  intelligence  so  as  to  provide  the  maximum 
revenue  for  a  minimum  of  capital  investment  and  operating 
expense.  Upon  the  successful  solution  of  this  problem  de- 
pends the  success  or  the  failure  of  the  small  utility. 

It  has  become  universally  recognized  that  an  intelligent 
placing  of  the  new  business  of  a  public  utility,  especially  an 
electric  company,  is  even  more  important  than  the  new  business 
itself.  For  this  reason  new  business  campaigns  are  carefully 
planned  by  the  new  business  engineers  of  the  holding  company, 
put  under  the  charge  of  a  man  or  woman  who  follows  definite 
prescribed  plans.     The  primary  lines  and  transformers  or  the 


242  CORPORATION  FINANCE  I XX 

mains  are  plotted,  the  points  and  areas  of  undersaturation  are 
noted,  and  the  new  business  soHcitor  concentrates  his  energy 
upon  these  points  or  areas.  The  trained  soHcitors  are  moved 
about  from  one  district  to  another  and  from  one  subsidiary 
to  another,  according  to  the  immediate  needs.  Ordinarily 
they  carry  on  their  work  independently  of  the  local  manage- 
ment, and  their  compensation  usually  consists,  in  part  if  not 
altogether,  of  commissions  on  the  new  services  they  succeed 
in  securing. 

Advantages  in  Financing. — But  after  all  has  been  said, 
there  is  little  doubt  but  that  the  most  conspicuous  help  that  the 
holding  company  renders  to  its  subsidiary  is  in  financial  mat- 
ters. This  shows  itself  in  two  ways.  The  holding  company 
assumes  the  obligation  of  rendering  both  temporary  and  per- 
manent financial  aid  to  its  subsidiary  operating  companies. 

The  outstanding  problem  of  all  public  utilities  since  the 
beginning  of  the  century  has  been  the  financial  problem  of 
obtaining  the  money  necessary  for  improvements  and  exten- 
sions. Since  the  widespread  adoption  of  the  Lowe  system 
of  gas  manufacture  and  the  universal  substitution  of  alter- 
nating for  direct  current  machinery  for  electric  companies, 
the  technical  advances  in  the  utilization  of  gas  and  electrical 
energy  have  outstripped  the  capital  available  with  which  to  take 
advantage  of  these  advances.  Because  of  their  public  nature, 
the  return  allowed  by  commissions,  the  courts,  and  public 
opinion  on  the  capital  invested  in  utilities  has  never  been  as 
liberal  as  that  available  to  the  capital  invested  in  a  well-man- 
aged bank  or  manufacturing  company.  They  have  bid  for 
capital  more  by  the  permanence  and  the  stability  of  the  indus- 
tries than  by  offering  liberal  interest  returns.  As  a  result, 
that  portion  of  the  savings  fund  of  the  community  available 
for  the  extensions  and  improvements  of  public  utilities  has 
been  inadequate  to  public  demands.     Severe  competition  en- 


XX]  THE  PUBLIC  UTILITY  HOLDING  COMPANY  243 

sued  among  the  utilities  themselves  for  what  was  available,  a 
competition  stimulated  by  the  incessant  clamor  of  the  public 
for  improved  service. 

In  the  presence  of  this  competition  for  capital,  that  utility 
has  fared  best  which  has  had  some  direct  financial  support. 
This  support  has  been  given  by  the  holding  company.  By  the 
ownership  of  the  controlling  shares — the  equity,  as  it  were — 
of  a  number  of  utilities,  the  capital  available  from  the  treasury 
of  the  parent  company  is  passed  over  to  the  subsidiary  to  be 
used  under  such  conditions  that  it  does  the  greatest  benefit. 
Weak  subsidiaries  are  tided  over  critical  periods — often  by 
the  use  of  the  credit  of  the  stronger  subsidiaries — and  the 
credit  of  the  whole  organization  is  made  available  to  those 
companies  which  are  so  small  or  so  deficient  in  earning 
capacity  that  they  have  no  independent  credit. 

The  simplest  means,  and  the  one  invariably  adopted  when 
the  credit  of  the  subsidiary  is  strong,  or  at  least  as  strong 
as  the  credit  of  the  holding  company,  is  to  have  the  subsidiary 
issue  its  own  bonds  and  preferred  stocks,  which  are  then  sold 
for  its  account  by  the  financial  department  of  the  holding 
company.  And  the  indirect  help  which  the  holding  company 
renders,  even  though  it  does  not  indorse  the  securities,  is  very 
great.  If  the  holding  company  believes  it  expedient  to  reinforce 
the  credit  of  the  subsidiary  by  its  own  credit,  it  may  either 
indorse  with  its  guaranties  the  subsidiary  securities,  or  it 
may  issue  securities  of  its  own  based  on  the  subsidiary  stocks, 
notes,  and  bonds  acquired  for  its  treasury.  But  these  guaran- 
teed bonds  and  collateral  trust  bonds,  having  been  issued  fre- 
quently in  the  past,  without  a  substantial  backing  of  real 
property  of  the  subsidiary,  these  indirect  methods  have  fallen 
out  of  favor.  By  reason  of  these  abuses  and  the  increasing 
strength  of  the  larger  holding  companies  which  have  weath- 
ered successfully  the  critical  periods  of  the  Great  War  there 
has  been  an  increasing  use   of   holding  company   preferred 


244  CORPORATION  FINANCE  I XX 

Stocks  and   debentures   for  meeting  the  costs  of   subsidiarj 
expansions. 

Financial  Structure. — A  study  of  their  financial  structure 
presents  difficult  problems  for  there  is,  usually,  hopeless  con- 
fusion in  reaching  both  the  net  capitalization  and  the  net 
earnings.  This  confusion  is  due  to  the  fact  that  both  sub- 
sidiaries and  holding  company  have  securities  outstanding, 
some  of  which  are  held  among  the  companies,  some  held  by 
parent  companies  as  collateral  on  the  basis  of  which  other 
securities  are  issued,  and  some,  finally,  are  in  the  hands  of  the 
public.  These  last  only  are  of  significance  in  estimating  either 
capitalization  or  earnings,  because  intercompany  securities  are, 
in  the  last  analysis,  only  bookkeeping  devices. 

To  reduce  the  capitalization  of  the  holding  company  to 
some  kind  of  intelligible  form,  an  exhaustive  study  was  made 
of  the  gross  and  net  capitalization  of  twelve  typical  holding 
companies.  These  twelve  holding  companies  and  their  sub- 
sidiaries had  outstanding  approximately  two  and  a  half  billion 
dollars  of  securities.  Of  this  amount  about  two-fifths  were 
represented  by  bonds,  two-fifths  by  common  stock,  and  one- 
fifth  by  preferred  stock.  Of  the  two  and  a  half  billion  dollars 
only  three-fifths  were  actually  owned  by  investors,  approxi- 
mately a  billion  of  this  being  in  bonds  bearing  fixed  charges; 
and  of  the  remaining  $500,000,000  half  was  in  preferred  and 
half  in  common  stocks.  The  rest  of  the  securities,  about  40 
per  cent,  were  held  in  the  treasuries  of  the  holding  or  sub- 
holding  company.  The  complete  control  was  vested  in  the 
common  stock,  which  represented  only  about  10  per  cent  of 
the  outstanding  securities. 

The  problem  of  constructing  standardized  income  and  ex- 
penditure accounts  of  the  holding  companies  and  of  accounting 
for  profits  between  holding  company  and  subsidiary  presents 
serious  difficulties.    One  perplexing  problem  is  to  get  the  earn- 


XX  ]  THE  PUBLIC  UTILITY  HOLDING  COMPANY  245 

ings  of  the  subsidiary  into  the  treasury  of  the  hokhng  company. 
If  all  the  securities  of  the  subsidiary  are  owned  by  the  holding 
company,  then  the  method  and  the  amount  of  compensation 
the  parent  may  demand  of  its  subsidiary  is  entirely  a  question 
of  bookkeeping.  But  if  there  is  a  considerable  minority  owner- 
ship in  the  securities  of  the  subsidiary,  then  it  becomes  a  matter 
of  importance  whether  the  earnings  of  the  subsidiary  are 
brought  into  the  holding  company's  treasury  partly  through  an 
arbitrary  service  charge  in  which  the  minority  security-holders 
have  no  share,  or  entirely  through  stock  dividends  in  which  the 
minority  interests  have  a  proportionate  participation.  In  an 
important  case  a  holding  company  charged  a  subsidiary  $2,000 
a  year  for  its  services.  The  Commission  ruled  that  this  was 
all  the  rate  payers  were  called  upon  to  bear,  even  though  it 
could  be  shown  that  the  local  utility  could  not  obtain  services 
of  equal  value  by  other  means  except  at  a  much  greater  cost. 
The  American  Telephone  and  Telegraph  Company  levies  on 
each  of  its  subsidiaries  a  charge  of  4^  per  cent  of  the  gross 
receipts  for  the  services  of  its  central  organization.  This 
includes  not  only  the  customary  legal,  technical,  financial,  and 
administrative  assistance  rendered  by  the  holding  company, 
but  also  a  rental  for  the  subscribers'  telephone  instruments,  all 
of  which  are  owned  by  the  holding  company. 

There  are  also  marked  differences  in  matters  of  accounting 
policy.  Some  holding  companies  permit  the  subsidiaries  to 
account  for  their  entire  earnings  as  their  own  corporate  prop- 
erty, merely  a  part  of  which  reaches  the  holding  company  in 
the  form  of  dividends.  Other  holding  companies  obliterate 
entirely,  apparently,  the  corporate  distinction  between  the 
parent  and  the  subsidiary,  and  claim  as  their  earnings  the  total 
aggregate  earnings  of  all  subsidiaries,  whether  or  not  they  have 
been  legally  distributed  as  dividends.  Furthermore,  there  is  no 
uniform  method  of  computing  depreciation  for  the  plants  and 
equipment  of  the  individual  operating  companies;  a  holding 


246  CORPORATION  FINANCE  [XX 

company  may  even  prescribe  different  policies  for  its  separate 
subsidiaries  when  state  laws  require  different  methods.  Several 
holding  companies  refuse  absolutely  to  make  public  the  earn- 
ings of  their  separate  subsidiaries.  In  some  cases  the  earnings 
from  local  utilities  are  commingled  with  earnings  from  oil 
properties,  for  several  of  the  larger  public  utility  holding 
companies  have  acquired  extended  investments  in  oil  wells  and 
even  in  oil  refining  and  distributing  companies. 

Forms  of  Public  Utility  Holding  Companies. — The  public 
service  holding  company  heretofore  described  exercises  abso- 
lute control  over  its  subsidiaries.  Subject  to  the  securities  of 
these  subsidiaries  in  the  hands  of  the  public,  it  may  be  said  to 
exercise  absolute  ownership.  But  there  are  other  forms  of 
public  utility  holding  companies  where  control  and  ownership 
are  neither  as  certain  nor  as  direct  as  in  these  cases.  Such 
instances  are  represented  by  three  different  types  of  public 
service  holding  companies,  each  organized  for  a  single  main 
purpose.  There  is,  first,  the  holding  company  organized  pri- 
marily for  distributing  investments  over  a  large  range  of 
utilities  operating  under  diverse  managements  and  in  diverse 
localities.  This  type  is  analogous  to  the  investment  company, 
pure  and  simple,  especially  in  the  sense  in  which  the  phrase 
is  used  in  England.  There  is,  again,  the  holding  company 
organized  for  the  specific  purpose  of  enabling  many  small 
undeveloped  operating  companies  to  market  their  bonds  during 
the  period  of  their  early  growth.  Often  holding  companies  of 
this  type  are  under  the  direct  tutelage  of  equipment  companies 
or  banking  houses.  There  is,  still  again,  the  holding  company 
organized  by  engineers  to  hold  small  interests  in  numerous 
operating  companies  over  which  they  exercise  the  managing 
control.  These  special  holding  companies,  especially  those  or- 
ganized to  hold  merely  common  stocks  of  subsidiaries  operated 
by  a  single  engineering  firm,  have  not  proved  very  successful. 


CHAPTER  XXI 

THE  COMMUNITY  OF  INTERESTS 

The  Ideal  Form  of  Organization. — All  the  forms  of  com- 
bination heretofore  described  represent  actual,  virtually  com- 
plete, consolidations  of  business  units.  The  ownership  and 
the  management  of  the  small  units  are  thoroughly  and  com- 
pletely merged.  The  component  parts  of  a  great  industrial 
"trust,"  a  great  railway  system,  or  a  great  power  company, 
are  merely  parts  to  a  completely  organized  whole.  They  have 
no  independent  ownership,  no  independent  financial  structure, 
and,  above  all,  their  directors  have  no  separate  power  of 
initiative.  The  name  of  a  branch  line  of  railway  may  be  re- 
tained and  there  may  be  outstanding  in  the  hands  of  the  public 
separate  issues  of  bonds,  but  the  branch  line  has  no  separate 
management  independent  of  the  management  of  the  whole 
railway  system.  Its  earnings  are  merged.  Its  schedules  of 
trains  are  made  to  fit  into  the  schedules  of  the  whole  system. 
If  it  preserves,  in  order  to  retain  some  old  non-transferable 
franchise,  a  separate  corporate  structure,  the  directors  and 
officers  are  the  same  as  those  of  the  whole  system,  or  else  are 
men  nominated  by  them.  In  brief,  the  branch  line  is  merged 
in  all  except  its  name  with  the  railroad  system  of  which  it 
forms  merely  one  of  many  parts. 

The  very  closeness  of  the  consolidation  has  been  attended 
by  many  disadvantages  not  obtained  in  the  small,  mobile,  and 
compact  business  unit — the  owner-manager  business,  in  which 
quickness  of  action  and  personal  initiative  go  a  long  way  to 
counterbalance  ignorance  and  lack  of  organization.  In  the 
"big  business"  often  the  largest  single  factor  in  an  industry — 
great  size  and  a  kind  of  perfection  of  mechanical  organization 

247 


248  CORPORATION  FINANCE  [XXI 

— do  much  to  counterbalance  the  lack  of  individual  initiative 
and  the  lack  of  personal  contact  with  employees  and  customs. 

The  type  of  mind  which  has  been  conspicuously  successful 
in  organizing  and  developing  big  businesses  thinks  and  acts  in 
terms  of  economic  generalities.  It  is  endowed  with  great 
imagination.  It  suppresses  differences  and  exaggerates  like- 
nesses. To  such  a  type  of  mind  details  are  abhorrent;  business 
is  to  be  unfolded  like  the  plot  of  a  great  drama,  in  which  indi- 
vidual character  and  incident  are  significant  only  as  they  further 
the  end.  Mere  size  is  its  own  justification.  And  under  the 
spell  of  men  of  this  type  business  strategy  becomes  a  mad  rush 
toward  consolidations,  holding  corporations,  and  other  devices 
which  make  it  possible  for  a  few  men  to  control  large  amounts 
of  labor  and  capital.  It  is  a  very  pertinent  question  :  Can  there 
be  a  form  of  business  organization  which  retains  the  initiative 
and  responsiveness  of  small  size  and  at  the  same  time  the  scope 
and  integration  of  the  big  organization? 

.  Evolution  of  Business  Organization. — Historically  business 
organization  has  moved  in  great  cycles  in  its  effort  to  answer 
this  question.  At  the  close  of  the  Civil  War  and  down  to  the 
depression  following  the  panic  of  1873,  American  manufactur- 
ing business  consisted  for  the  most  part  of  small  independent 
units.  These  simple  busin>.sses  were  owned  and  managed  by  a 
single  individual,  by  the  heirs  or  the  members  of  the  family  of 
the  founder,  or  by  a  group  of  local  merchants  who  subscribed 
to  the  stock  of  the  local  mill.  However  existing,  whether 
proprietary  or  a  locally  owned  corporation,  the  business  was 
narrowly  limited  in  size  and  in  scope  of  activities.  Competi- 
tion was  severe.  Co-operation  of  any  kind  was  unknown, 
and  motives  of  industrial  independence  and  isolation  governed 
the  business  policy  of  American  manufacturers. 

In  the  years  before  the  panic  of  1873,  railroad  construction 
and  consolidation  had  so  widened  the  area  within  which  com- 


XXI  ]  THE  COMMUNITY  OF  INTERESTS  249 

peting  manufacturers  could  sell  their  product  that  in  the  boom 
period  following  the  depression  of  the  middle  seventies  com- 
petition was  extended  over  a  wider  field  than  ever  before. 
Under  the  stimulus  of  an  increasing  volume  of  business  and 
rising  prices,  manufacturers  invaded  each  other's  territory. 
Competition  reached  an  unprecedented  degree  of  severity,  and 
in  this  competition  the  larger  units  were  able,  by  rebates  and 
midnight  tariffs,  to  secure  more  advantages  from  the  carriers 
than  the  smaller  units  through  rampant  individualization  and 
cutthroat  competition.  The  pendulum  began  to  swing  toward 
larger  units  and  co-operative  trade  practices. 

Gentlemen's  Agreements. — The  first  stage  in  this  evolu- 
tion, both  historical  and  logical,  was  the  gentlemen's  agreement 
governing  the  area  of  competition.  Often  as  a  result  of  a 
casual  meeting  manufacturers  agreed  not  to  send  salesmen  into 
each  other's  territory.  The  second  step  was  the  gentlemen's 
price  agreement,  likewise  often  the  result  of  a  mere  casual 
conversation.  The  manufacturers  agreed  upon  a  minimum 
base  price,  below  which  they  would  not  sell  their  goods.  In 
both  of  these  instances,  there  were  no  written  contracts,  for 
even  before  the  passage  of  the  Sherman  Act  in  1890,  it  was 
vaguely  felt  that  all  such  agreements  were  contrary  to  the 
common  law  of  restraint  of  trade.  Business  men  merely  agreed 
that  they  would  be  bound  by  their  verbal  agreement  "on  their 
honor  as  gentlemen." 

The  gentlemen's  agreements  with  regard  to  the  territorial 
distribution  of  sales  and  with  regard  to  cutting  prices  were 
both  usually  broken.  The  manufacturers  could  not  be  held 
in  law  or  equity  to  observe  their  agreements,  and  there  was 
no  other  way  of  enforcing  them.  Competition  which  had 
extended  over  years,  possibly  over  generations,  could  not  be 
annulled  by  a  verbal  understanding  the  very  nature  of  which 
was  at  variance  with  our   Anglo-Saxon   law.      Accordingly, 


250  CORPORATION  FINANCE  [XXI 

some  kind  of  loose  but  centralized  and  direct  control  had  to 
be  voluntarily  endured  by  the  manufacturers  in  order  to  render 
their  verbal  agreements  effective.  Such  a  centralized  icontrol 
was  first  accomplished  by  the  pool. 

Pools. — All  pools  had  as  their  immediate  object  the  direct 
control  over  the  production  or  the  distribution,  or  both,  of 
all  the  co-operating  manufacturers-  This  control  was  invari- 
ably vested  in  a  central  bureau  which  attempted  to  exert  a 
mild  dictatorship.  On  the  relative  strength  of  this  dictator- 
ship and  the  means  at  hand  to  enforce  it  depended  the  relative 
strength  of  the  pool  and  its  position  in  the  evolution  from  the 
rudimentary  gentlemen's  agreement  to  the  true  business 
consolidation. 

The  managers  of  the  simplest  pool  sought  merely  to  dis- 
tribute the  output  of  the  members.  The  central  bureau,  usually 
represented  by  a  paid  secretary,  apportioned  the  business 
available  in  accordance  with  a  prearranged  schedule.  This 
schedule  sought  to  aliquate  to  each  manufacturer  an  amount 
of  the  available  business  that  was  proportional  to  his  total 
producing  or  distributing  capacity.  But  such  pools  were  in- 
effective because  the  central  bureau  had  no  real  authority 
to  hold  each  manufacturer  to  his  proportional  allotment.  A 
second  type  of  pool  required  that  the  manufacturers  belonging 
should  bid  among  themselves  for  contracts,  the  proceeds  of 
the  bids  being  distributed  among  the  members  of  the  pool. 
The  cause  celebre  of  this  type  was  the  pool  of  manufacturers 
of  cast  iron  pipe,  known  colloquially  as  the  Addystone  Pipe 
Pool.  The  case  acquired  considerable  notoriety  because  the 
decision  of  the  United  States  Supreme  Court  condemning 
the  organization  of  their  particular  pool  constitutes  an  impor- 
tant, perhaps  nodal,  point  in  the  evolution  of  the  judicial 
interpretation  of  the  Sherman  Act  of  1890.  A  third,  and 
by  far  the  most  important  type  was  known  as  the  "paying-in 


XXI]  THE  COMMUNITY  OF  INTEREvSTS  25 1 

and  drawing-out"  pool.  The  cases  of  this  type  were  very 
numerous.  They  were  based,  as  were  the  two  simpler  types, 
on  the  distribution  of  the  available  business  according  to  the 
total  net  capacity  of  the  manufacturers  belonging  to  the  pool. 
Those  manufacturers  whose  sales  exceeded  their  proportioned 
allotments  were  to  pay  to  the  central  treasury  the  total  net 
profit  realized  in  excess  of  their  allotment.  And  on  the 
other  hand,  those  manufacturers  whose  sales  fell  below  their 
proportioned  allotment  drew  from  the  pool's  treasury  the 
net  profit  on  sales  representing  the  difference.  No  manu- 
facturer belonging  to  the  pool  could,  therefore,  obtain  an 
increased  profit  through  an  increase  of  sales.  Thus  there  was 
presumably  no  incentive  for  a  manufacturer  to  cut  under  the 
selling  price  agreed  upon  by  the  pool  in  order  to  increase  his 
sales.  But  even  these  closely  organized  pools  failed  of  their 
object  either  because  of  the  growth  of  outside  competition,  or 
because  of  the  deceit  and  perfidy  of  the  members.  In  the 
instance  of  one  such  pool  the  history  of  which  came  under 
the  writer's  observation,  an  important  member  kept  two  sets 
of  books.  One  set  showed  his  true  sales  and  was  kept  for 
his  own  information.  The  other  was  a  fictitious  record  of 
sales  prepared  especially  for  the  inspection  of  the  pool's  auditor 
in  such  a  manner  as  to  show  much  smaller  sales.  In  this 
manner  the  manufacturer  could  make  a  surreptitious  profit 
through  an  excess  of  sales  beyond  his  allotment  without  being 
forced  to  pay  back  the  profit  to  the  pool's  treasury.  This 
ingenious  plan  was  soon  discovered  by  another  member  and  it 
immediately  caused  the  disruption  of  the  pool. 

In  consequence  of  their  lack  of  force,  pools  of  all  descrip- 
tions tended  to  break  up.  After  repeated  efforts  manufac- 
turers adopted  the  trust  form  of  organization  and  later  the 
true  corporation,  but  these  later  and  advanced  stages  in  the 
evolution  of  business  organization  have  been  treated  already 
in  the  sections  dealing  with  industrial  consolidation. 


252  CORPORATION  FINANCE  [XXI 

Intermediate  Forms.— Notwithstanding  the  development  of 
the  more  highly  organized  forms  of  business  organization  and 
the  universal  acknowledgment  of  the  efficacy  of  the  large 
corporation  as  a  means  of  carrying  on  certain  types  of  busi- 
ness, the  defects  of  mere  size  are  apparent.  These  were  dis- 
cussed at  some  length  in  a  preceding  chapter  and  need  not 
be  repeated  here.  But  the  thing  of  importance  is  that  these 
defects  are  being  more  and  more  fully  recognized,  and  with 
this  recognition  a  reaction  has  set  in  toward  the  adoption  of 
the  smaller  business  unit.  Mere  consolidation — mere  bulk — 
is  not  of  itself  and  of  necessity  a  source  of  strength.  With 
this  acknowledgment  the  permanent,  if  not  the  paramount, 
problem  of  our  contemporary  industrial  democracy  becomes 
the  working  out  of  the  relations  between  the  large  and  small 
business,  and  the  bearing  of  each  upon  the  problems  of  the 
economical  use  of  labor  and  capital.  The  solution  is  not  in 
working  back  over  the  road  along  which  industrial  evolution 
passed  from  the  small  business  to  the  great  corporation.  The 
historical  forms  through  which  this  evolution  passed  were 
negative.  Gentlemen's  agreements,  pools,  and  the  like,  had 
as  their  object  the  stifling  of  competition.  The  intermediate 
forms  now  sought  are  positive.  Industry  is  in  a  flux.  Ease 
of  transportation,  the  general  dissemination  of  technical 
knowledge,  the  scarcity  of  labor,  the  great  accumulation  of 
funds  waiting  for  investment — all  facilitate  the  formation  of 
large  units.  In  consequence  the  intermediate  forms  which 
are  now  coming  into  prominence  seek  to  temporize  the  in- 
herent defects  of  big  business  with  some  degree  of  the  free- 
dom and  spontaneous  initiative  of  highly  individualized  and 
independent  parts.  An  exhaustive  summary  of  such  forms 
is  not  within  the  present  purpose,  but  two  general  movements 
deserve  rather  detailed  attention  both  because  of  their  own 
significance  and  because  of  the  balance  between  the  large  and 
the  small  that  they  illustrate.     They  are  the  association — a 


XXI  ]  THE  COMMUNITY  OF  INTERESTS  253 

loose,  but  co-ordinated  form  of  union — and  the  community 
of  interests — a  closer  form  of  union  with  a  limited  concentra- 
tion of   financial   responsibility. 

The  problems  today  are  not  so  much  those  of  suppressing 
competition  as  those  of  mutual  protection  against  the  demands 
of  labor  unions,  the  assessment  of  inordinate  taxes,  and  the 
enactment  of  unfavorable  tariff  legislation  on  the  negative 
side;  and  the  development  of  trade  advantages  in  the  presence 
of  competitive  substitutes  and  the  exploitation  of  foreign 
markets  on  the  positive  side.  Both  the  district  associations 
and  the  trade  associations  illustrate  these  problems. 

District  Associations. — The  Manufacturers'  and  Em- 
ployers' Association  of  Taunton  formed  in  191 7  is  a  good 
illustration  of  the  direct  association.  In  1920  it  comprised 
40  different  employing  corporations  representing  upwards  of 
7,000  employees.  Its  by-laws  and  constitution  are  somewhat 
illusive  and  propose  as  the  objects  of  the  association  the 
furthering  of  the  industrial  and  commercial  welfare  of  the 
Taunton  district,  and  fostering  among  the  members  of  the 
association  "a  spirit  of  friendliness  and  progress."  In  detail, 
it  proposes  to  equalize  and  specialize  wages,  to  reduce  labor  in 
"turnover,"  and  to  protect  the  Taunton  district  against  unfair 
freight  rates.  Its  officers  consist  of  a  president,  whose  position 
is  purely  honorary,  and  a  salaried  secretary,  upon  whom  de- 
volve the  affairs  of  the  association.  Almost  from  the  first,  its 
problems  centered  about  labor,  and  to  meet  these  labor  prob- 
lems in  detail  the  association  at  an  earlier  date  adopted  certain 
general  policies.  The  association  advocates  that  the  wages 
paid  in  any  one  plant  be  not  lower  than  the  wages  in  another 
plant  doing  the  same  kind  of  work.  The  association  advocates 
that  the  hours  of  labor  and  general  working  conditions  be 
uniform  through  the  district,  unless  circumstances  determine 
that  they  be  otherwise.     The  association  seeks  to  have  knowl- 


254  CORPORATION  FINANCE  I XXI 

edge  of  all  labor  conditions  throughout  the  area.  It  carries 
on  an  employment  bureau  for  the  benefit  of  the  members  and 
labor  in  general.  If  a  strike  threatens,  the  association  through 
its  secretary  and  its  executive  board  conducts  an  investigation 
on  its  own  behalf.  If  this  investigation  shows  that  the  em- 
ployees are  demanding  no  more  than  economic  conditions 
warrant  or  other  manufacturers  engaged  in  the  same  business 
are  paying,  then  the  association  decides  for  the  men  and  exerts 
its  pressure  to  force  the  employing  firm  to  accede  to  the  de- 
mands. If,  on  the  contrary,  the  investigation  shows  that  the 
employees  are  making  unreasonable  demands,  the  pressure  of 
the  association  is  exerted  to  break  the  strike. 

The  organization  of  such  an  association  is  much  stronger 
than  the  ordinary  chamber  of  commerce.  Its  secretary — the 
title  usually  bestowed  upon  the  man  who  serves  as  the  general 
manager  of  the  organization — exerts  an  almost  autocratic 
power  among  the  members.  He  may  practically  order  one 
manufacturer  to  increase  his  wage  schedule  if  it  appears  that 
the  industrial  peace  of  the  community  requires  it,  or  he  may 
for  the  same  reason  order  another  manufacturer  to  decrease 
his.  If  there  is  a  strike  in  the  plant  of  a  member  of  the  asso- 
ciation, it  becomes  a  matter  of  concern  of  the  entire  association. 
If  it  is  obvious  to  the  acute  intelligence  of  the  association's 
secretary  that  the  men  on  strike  have  a  justifiable  ground  for 
complaint,  or  that  a  quick  settlement  of  the  dispute  is  wise 
from  the  point  of  view  of  economic  expediency,  then  the  secre- 
tary will  adjust  the  dififerences,  quite  generally  in  favor  of  the 
men,  and  order  the  manufacturer  to  accept  the  decision.  If  the 
manufacturer  refuses  he  is  dropped  from  the  association. 
If,  on  the  contrary,  it  is  apparent  to  the  association's  secretary 
that  labor  troubles  would  be  fomented  in  other  industries 
should  the  striking  laborers  obtain  their  demands,  or  that 
their  success  would  establish  a  dangerous  precedent,  then  the 
association  as  a  whole,  on  the  recommendation  of  the  secretary 


XXI  ]  THE  COMMUNITY  OP  INTERESTS  255 

or  an  investigating  committee,  assumes  the  responsibility  for 
the  strike.  The  manufacturer  suffering  from  the  labor  trouble 
obtains  the  support  of  the  manufacturers  of  the  entire  district. 
The  association  bears  the  expense  out  of  the  proceeds  of 
assessments  levied  on  all  members. 

Agricultural  District  Associations. — District  associations 
are  not  confined  to  industrial  localities  where  the  management 
of  labor  is  perhaps  the  most  insistent  problem.  They  are  very 
common  and  very  influential  in  agricultural  districts  devoted 
to  the  production  of  a  single  commodity.  Here,  however,  the 
problems  that  absorb  the  attention  of  the  association  are  not 
those  of  production  but  of  distribution.  In  consequence  the 
products  of  all  the  members  of  the  association  are  marketed 
by  the  association  under  a  single  generic  name,  such  as 
"Sunkist  Oranges"  or  "Sun-Maid  Raisins."  Expenses  of  ad- 
vertising, of  car-load  shipments,  of  wholesale  merchandising, 
which  no  one  producer  could  afford  to  bear  alone,  are  shared 
by  all  the  members  of  the  association  in  proportion  to  the 
production  of  each.  True,  the  association's  secretary  may 
prescribe  conditions  of  excellence  with  which  the  fruit  of  each 
member  must  comply  before  its  sale  is  undertaken  by  the  asso- 
ciation, but  these  conditions  have  regard  only  to  character  or 
quality  of  the  product,  not  to  the  methods  followed  or  the 
economy  in  raising  the  product  or  the  wages  and  working 
conditions  of  the  labor  employed  by  the  planter.  These  are 
left  to  the  personal  initiative  of  each  member  of  the  association. 

There  are  many  associations  which  meet  to  a  greater  or 
less  extent  the  general  description  of  these  district  associations. 
The  great  difficulty,  as  with  all  associations,  pools,  and  volun- 
tary trade  agreements,  is  to  secure  such  unanimity  of  mem- 
bership that  the  decisions  of  the  association  command  respect 
and  secure  the  strength  that  comes  of  the  voluntary  action 
of  a  united  body.     Membership  is  entirely  a  matter  of  self- 


256  CORPORATION  FINANCE  XXI 

interest.  A  weak  association  defeats  its  own  ends,  and  this 
weakness  may  be  due  either  to  lack  of  support  from  the 
members  of  a  district,  or  else  to  a  vacillating,  stupid,  or  head- 
strong secretary  and  executive  committee.  Experience  has 
shown  it  to  be  unquestionably  true  that  district  associations 
of  this  character  achieve  worth-while  ends  only  if  they  receive 
practically  the  unanimous  support  of  all  the  manufacturers 
within  the  district,  and  are  led  by  liberal-minded,  tolerant,  and 
courageous  men. 

Manufacturers'  Associations. — Another  type  of  association 
is  that  of  the  manufacturers  or  producers  in  a  given  line  of 
business.  Membership  is  based  on  the  nature  of  the  product 
rather  than  on  geographical  location.  Their  purpose,  unlike 
that  of  the  earlier  pools,  is  positive — to  familiarize  the  public 
with  the  products  of  the  industry,  to  secure  tarifif  legislation 
favorable  to  the  industry,  to  prevent  repressive  or  harmful 
legislation,  to  retain  competent  counsel  to  represent  the  industry 
at  judicial  hearings. 

One  of  the  best  examples  of  such  a  coherent  and  highly 
organized  manufacturers'  association  exerting  itself  both  in 
the  direction  of  increasing  the  demand  for  the  products  of 
the  industry  and  in  the  direction  of  defending  the  industry 
against  legislative  attack,  is  afforded  by  the  American  Manu- 
facturers' Association  of  Products  from  Corn.  As  this 
association  is,  by  reason  of  the  small  number  of  concerns 
engaged  in  the  Avet  milling  of  corn,  rather  a  compact  and 
highly  developed  manufacturers'  association,  it  i?  worth  while 
to  examine  its  tenets  and  its  activities  at  some  length. 

For  many  years  the  American  manufacturers  of  glucose 
and  starch  made  from  corn  had  fought  against  a  popular  preju- 
dice against  the  use  of  glucose  as  a  food.  In  the  minds  of 
some  people  this  prejudice  was  due  to  the  similarity  between 
the  words  "glucose"  and  "glue" ;  in  the  minds  of  others  it 


XXI]  THE  COMMUNITY  OF  INTERESTS  257 

was  due  to  the  original  use  of  sulphuric  acid  as  a  catalytic 
agent  by  Kirchof  and  by  the  early  commercial  manufacturers. 
But  the  missionary  work  carried  on  by  each  manufacturer  was 
desultory;  it  was  an  unimportant  part  of  his  general  policy 
in  advertising.  In  191 2,  it  occurred  to  certain  men  in  the 
industry  that  this  work  of  educating  the  public  to  the  uses 
of  the  products  of  corn  and  of  defending  the  industry  against 
popular  prejudice  could  be  carried  on  best  by  an  association 
in  which  all  the  manufacturers  concerned  contributed  to  the 
expenses  in  proportion  to  the  benefits  derived  from  the  work. 
Accordingly  such  an  association  was  formed  March  12,  191 3. 
The  objects  of  the  association  are  specifically  defined  by 
its  constitution  as : 

First.  To  maintain  the  standard  of  purity  and  quality  of 
products  from  corn  in  all  possible  ways. 

Second.  To  take  united  action  in  correcting  all  opinions 
adversely  and  unjustly  affecting  the  consumption  and  uses  of 
products  from  corn. 

Third.  To  educate  the  dealers  in  and  consumers  of  products 
from  corn  in  regard  to  the  purity,  wholesomeness  and  uses  of 
said  products. 

Fourth.  To  take  united  action  in  respect  to  all  questions  be- 
fore State  or  National  Legislatures  wherein  untrue  impressions 
in  regard  to  the  nature  and  uses  of  products  from  corn  are  in- 
volved, and  whereby  unjust  rules,  regulations,  standards  or  laws 
restricting  or  adversely  affecting  the  sale  of  products  from  corn 
may  ensue. 

In  addition  to  these  efforts  to  increase  the  consumption 
of  corn  products,  the  association  has  fought  legislation  which 
might  tend  to  decrease  their  use  or  further  prejudice  the  people 
against  them.  For  example,  it  prepared  the  case  for  the  glucose 
manufacturers  in  the  "Hearing  before  Illinois  State  Food 
Standards  Commission  in  the  Matter  of  Investigation  of  Corn 
Syrup   (Glucose)  and  Its  Use  in  Foods,  January  22,  1916." 


258  CORPORATION  FINANCE  [XXI 

And  the  association  has  been  active  whenever  and  wherever 
efforts  have  been  made  in  state  legislatures  to  enact  statutes 
prohibiting,  restricting,  or  limiting  the  sale  or  consumption 
of  corn  products,  particularly  glucose. 

The  activities  for  increasing  the  demand  may  also  take 
the  form  of  exploiting  foreign  markets.  Many  manufacturers' 
associations,  notably  in  the  copper,  steel,  and  textile  industries, 
had  bent  their  efiforts  toward  foreign  selling — even  before 
the  Great  War.  And  when  the  liberal  privileges  of  the  Webb 
Act  are  more  fully  understood  the  activities  of  these  associa- 
tions in  this  direction  will  undoubtedly  be  increased. 

The  other  important  activities  of  these  associations  are 
in  the  direction  of  the  protection  of  the  industry  against  legis- 
lative or  political  attack.  The  manufacturers'  associations  in 
the  textile  industry,  for  example,  have  already  sought  to  in- 
fluence tariff  legislation  for  the  benefit  of  their  own  interests ; 
associations  of  manufacturers  of  boots  and  shoes  have  be- 
stirred themselves  when  the  tariff  on  hides  came  under  dis- 
cussion. Many  industries  are  subject  to  indirect  attack  through 
special  legislation.  The  Investment  Bankers'  Association  has 
fought,  in  the  lobbies  of  the  state  legislature  and  in  the 
courts,  the  enactment  of  blue-sky  statutes.  Associations  of 
food  manufacturers  have  fought  "labeling"  and  "branding" 
laws;  associations  of  fire  underwriters  have  fought  state  fire 
insurance;  and  liability  underwriters  the  various  forms  of 
compulsory  state  liability  insurance.  In  all  these  and  in  similar 
cases,  the  associations  exist — indeed,  they  were  often  orga- 
nized— for  defensive  purposes,  but  their  influence  usually 
develops  along  constructive  lines. 

Community  of  Interests  in  Production  and  Distribution. — 
A  community  of  interests  represented  by  directed  dependence 
of  the  units  on  each  other  for  the  purchase  and  sale  of  some 
commodity  is  another  form  of  loose  combination   relatively 


XXI]  THE  COMMUNITY  OF  INTERESTS  259 

common  in  modern  business.  It  works  out  in  the  following 
manner.  A  manufacturer  of  an  expensive  or  complex  product 
requires  some  semi  fabricated  material  or  some  specialized  part. 
He  requires  this  material  or  this  part  in  large  quantities,  in 
regular  and  dependable  deliveries.  Yet  his  own  business  re- 
quires all  his  time  and  capital  and  is  of  an  absolutely  different 
character.  He  may  make  automobiles,  for  which  starting 
and  lighting  generators  are  required.  Yet  the  automobile 
business  is  absolutely  different  from  the  electric  business.  He 
may  corrode  white  lead  for  painters,  for  which  large  quanti- 
ties of  metallic  lead  are  required.  Yet  a  successful  corroder 
and  a  successful  miner  can  with  difficulty  be  combined  in  the 
same  person.  Under  these  circumstances  an  agreement  is 
entered  into  between  the  two  manufacturers  under  which  one 
agrees  to  manufacture  the  product  required  by  the  other  in 
such  quantities  and  according  to  such  specifications  as  may 
be  mutually  decided  upon,  and  correlatively  the  other  manu- 
facturer agrees  to  purchase  the  product  under  pre-arranged 
conditions  of  delivery  and  payment.  The  buying  expenses  of 
one  and  the  selling  expenses  of  the  other  are  saved,  and  both 
are  relieved  of  uncertainty  regarding  future  supply  and  de- 
mand. Once  the  agreement  is  undertaken,  each  becomes 
mutually  important  to  the  other;  and  if  the  product  manu- 
factured by  one  and  purchased  by  the  other  is  a  relatively 
highly  specialized  part,  like  a  generator  for  an  automobile  or 
a  governor  for  a  turbine,  the  two  manufacturers  might  even 
be  said  to  be  necessary  to  each  other.  At  all  events  there  is 
a  very  close  community  of  interests. 

During  the  last  decade  it  is  probable  that  the  automobile 
industry  showed  the  most  conspicuous  use  of  this  kind  of 
community  of  interests  among  business  units.  The  industry 
developed  very  rapidly.  It  absorbed  in  its  rapid  growth  very 
large  amounts  of  capital.  Yet  investors  regarded  it  as  at  best 
uncertain,  even  precarious,  so  that  automobile  manufacturers 


26o  CORPORATION  FINANCE  [XXI 

were  forced  to  secure  most  of  their  capital  from  local  banks 
and  from  the  reinvestment  of  surplus  in  the  business.  As  a 
result  they  were  forced  to  limit  their  scope  of  operation,  and 
one  of  the  ways  in  which  this  was  done  was  to  contract  with 
other  manufacturers  for  the  purchase  of  special  parts  and 
accessories. 

Community  of  Interests  in  Stock  Ownership. — Distinctly 
the  commonest  form  of  community  of  interests,  in  which 
individuality  and  unity  of  purpose  have  been  successfully 
combined,  is  in  businesses  loosely  bound  together  through  the 
common  ownership  of  minority  stock  interests.  This  kind 
of  community  of  interests  is  found  in  an  industry  where  there 
is  no  other  sign  of  co-ordination  and  it  is  especially  common 
in  a  manufacturing  industry  constituted  of  many  separately 
owned  plants  confined  to  one  geographical  locality.  In  a  one- 
industry  town,  for  example,  a  dozen  or  more  competing  plants 
are  engaged  in  the  production  of  one  and  only  one  product, 
like  the  jewelry  of  Attleboro,  the  chairs  of  Gardner,  or  the 
shell  goods  of  Leominster.  In  such  a  case  a  few  prominent 
manufacturers,  men  recognized  to  be  the  leaders  of  the  indus- 
try, will  be  found  to  be  directors  in  a  number  of  competing 
factories.  They  have  small  stockholdings  in  these  competing 
organizations  so  that  their  horizon  extends  to  the  welfare  of 
the  industry  as  a  whole  and  is  not  confined  to  one  factory. 
Through  the  influence  of  these  men  some  kind  of  harmony 
among  all  the  producers  in  the  tow^n  or  locality  is  obtained. 
In  no  sense  can  it  be  said  that  there  is  real  consolidation  of 
operating  plants,  but  there  is  a  real  co-operative  unity  based 
on  mutual  financial  interest  in  each  other's  welfare  and  on  a 
mutual  understanding  of  each  other's  business  problems. 

Community  of  Interests  in  Foreign  Trade. — One  of  the 
most  recent  of  these  corporate  community  of  interests,  and 


XXI]  THE  COMMUNITY  OF  INTERESTS  26 1 

one  perhaps  destined  to  achieve  considerable  importance,  is 
found  in  the  field  of  our  rapidly  developing  foreign  trade 
corporations.  As  pointed  out  in  another  connection  these 
enterprises  arose  in  response  to  the  opening  up  of  new  avenues 
of  foreign  trade  in  consequence  of  the  changes  brought  about 
by  the  Great  War.  A  foreign  exporting  and  importing  busi- 
ness to  be  successful  must  have  close  affiliations  with  manu- 
facturing, transporting,  and  banking  companies.  In  fact  its 
business  is  primarily  that  of  supplying  a  service  intended  to 
bring  about  the  efficient  co-operation  of  these  agencies  in 
foreign  commerce.  Accordingly,  the  foreign  trade  companies, 
in  order  to  strengthen  their  position  in  this  country  and  to 
fortify  their  agency  business  abroad,  have  sought  to  secure 
a  community  of  interests  among  businesses  upon  which  they 
are. directly  dependent.  This  takes  the  form  of  direct  stock 
control  in  some  instances,  but  such  control  involves  a  large 
investment  of  capital,  whereas  the  trading  company  would 
ordinarily  prefer  to  keep  its  available  capital  in  its  own  busi- 
ness. Unless  the  trading  company,  therefore,  has  large 
resources,  or  can  acquire  control  of  the  affiliated  business  with 
only  a  small  expenditure,  it  must  content  itself  with  resting 
its  community  of  interest  on  the  ownership  of  less  than  a 
majority  of  stock.  Great  as  are  the  financial  resources  of  the 
American  International  Corporation,  and  strong  as  is  the 
community  of  interest  among  its  affiliated  companies,  its  in- 
fluence in  three  of  the  largest  and  most  important  of  them  is 
assured  only  through  the  ownership  of  distinctly  less  than  a 
controlling  stock  interest. 

The  Family  Group. — Probably  the  most  comprehensive  and 
highly  organized  community  of  interests  is  when  one  large 
and  important  corporation  owns  a  share  in  a  great  number 
of  small  corporations,  all  carrying  on  an  allied  business,  and  the 
whole   constituting   a  kind   of    family   group.    This   kind   of 


262  CORPORATION  FINANCE  [XXl 

organization  is  not  common  because  it  is  too  intricate  to 
develop  easily.  Nevertheless  when  a  comprehensive  plan  is 
evolved  by  a  business  genius  possessing  a  true  breadth  of 
understanding,  it  represents  what  is  probably,  in  a  sense,  the 
highest  type,  and  the  furthest  development,  of  modern  cor- 
porate organization. 

In  its  ideal  form  this  type  of  community  of  interests 
requires  a  strong  central  corporate  organization,  possessing 
almost  unlimited  credit  and  unbounded  public  confidence.  It 
must  be  managed  by  men  who  have  the  rare  sense  of  inspiring 
confidence  and  independence  of  action  in  higher  executives 
and  the  ability  to  promote  true  co-operation  without  making 
the  affiliated  concerns  and  their  officers  mere  cogs  in  a  great 
machine.  In  other  words,  it  must  solve,  practically,  the 
theoretical  problem  of  the  proper  balance  between  concentra- 
tion of  control  and  administration,  and  spontaneity  of  in- 
dividual effort. 

Probably  no  business  organization  would  profess  that  it 
has  solved  this  problem,  in  a  sense  the  central  problem  of 
business  administration.  But  some  have  come  far  nearer  to 
a  solution  than  others.  Among  those  which  have  consciously 
sought  to  obtain  a  true  community  of  interests  and  preserve 
a  spirit  of  real  independence  among  the  subsidiaries  is  the 
group  of  affiliated  enterprises  known  as  the  "General  Electric 
family."  The  success  with  which  the  community  of  interests 
idea  has  been  worked  out  by  the  managers  of  the  General 
Electric  Company  is  worthy  of  something  more  than  passing 
comment. 

The  General  Electric  Company's  community  of  interests, 
as  now  constituted,  consists  of  subsidiaries  and  affiliations  of 
five  different  types,  differing  in  the  closeness  of  control  exer- 
cised by  the  parent  organization.  There  are  certain  subsidiaries, 
owned  entirely  by  the  parent,  of  which  the  parent  company 
exercises   entire   control   and   management.      These   may   be 


XXI]  THE  COMMUNITY  OF  INTERESTS  263 

looked  upon  as  loosely  articulated  departments  of  the  mam 
business.  The  other  four  types  of  affiliated  corporations  vary 
in  the  degree  of  closeness  of  union  with  the  parent  concern. 
In  none  of  these  types  of  corporations,  notwithstanding  the 
General  Electric  Company  may  hold  the  entire  stock,  does  it 
presume  to  exercise  an  administrative  control.  In  brief,  these 
types  are :  ( i )  those  companies  in  which  the  General  Electric 
Company  owns  a  majority  of  the  entire  stock,  but  which  are 
managed  by  a  separate  organization  quite  independent  of  the 
parent;  (2)  those  of  which  the  General  Electric  Company 
may  own  a  majority  stock,  indirectly  through  affiliated  in- 
terests, but  which  are  operated  as  separate  and  entirely  inde- 
pendent businesses;  (3)  those  in  which  the  General  Electric 
Company  owns  only  a  minority  stock  interest,  but  which 
operate  in  harmony  with  the  whole  organization;  (4)  those 
with  which  the  General  Electric  Company  has  operating  and 
pooling  agreements. 


CHAPTER  XXII 

FINANCING  OF  EXTENSIONS  FROM  THE  PUBLIC 

The  Problem  of  New  Capital. — The  four  preceding  chap- 
ters have  dealt  with  the  forms  of  business  organization  to  be- 
followed  by  an  expanding  business  and  by  consolidations.  Ex- 
cept incidentally,  little  reference  was  made  to  the  means  avail- 
able; yet  this  is  a  question  of  great  importance.  During  times 
of  large  surplus  of  investment  funds,  when  the  rates  on  bank 
loans  are  low  and  long-term  securities  are  in  great  demand,  the 
corporation  has  merely  to  justify  its  policy  of  expansion  by  the 
most  superficial  analysis  in  order  to  get  the  requisite  new  capital. 
But  when  surplus  investment  funds  are  scarce  and  banks  are 
restricting  rather  than  expanding  loans,  the  availability  of 
money  becomes  the  crux  of  any  policy  of  expansion.  It  is  this 
question  of  the  sources  of  new  capital  that  must  be  fairly  faced 
under  any  circumstance,  whatever  the  resources  of  the  corpora- 
tion. 

The  Investment  of  Earnings. — It  is  illuminating  to  look 
at  the  life  history  of  a  corporate  enterprise  as  consisting  of 
three  great  periods,  analogous  to  the  periods  under  which  the 
physiographer  describes  the  life  cycle  of  land  forms.  There 
is  a  period  of  youth  in  the  history  of  every  corporation;  there 
is  a  period  of  maturity;  and  there  is  a  period  of  old  age  and 
decay.  In  a  thoroughly  typical  case  the  period  of  youth  is  the 
period  of  growth.  But  it  is  growth  from  within,  since  it  is 
well-nigh  impossible  to  enlist  the  aid  of  outside  capital  in  a 
young  expanding  industry.  Much  if  not  all  of  the  capital 
required  for  this  growth  must  therefore  be  extracted  from  the 
business   itself,   namely,    from   the   reinvestment   of   earnings 

264 


XXII]      FINANCING  EXTENSIONS  FROM  THE  PUBLIC  265 

And  this  is  conspicuously  true  if  not  only  the  corporation  itself, 
but  the  industry  in  which  it  operates,  is  young  and  growing. 
Neither  banks  nor  investors,  neither  old  women  nor  speculators, 
care  to  assume  the  double  risk  of  both  an  undeveloped  industry 
and  an  untried  corporate  management.  All  the  funds  for  ex- 
pansion must  therefore  come  out  of  earnings.  Gradually  as  the 
industry  develops  and  exhibits  its  inherent  earning  capacity  or 
as  the  corporation  shows  successive  years  of  liberal  net  earn- 
ings, in  other  words,  as  it  approaches  the  maturity  period  of 
its  life  cycle,  capital  may  be  obtained  from  banks  and  investors. 
But  even  then  the  investment  credit  of  a  corporation  is  very 
much  improved  if  investors  feel  that  the  managers  of  the 
industry  are  willing  to  reinvest  at  least  a  part  of  their  annual 
earnings  in  the  business  for  which  they  seek  capital  from  out- 
side sources. 

Expansion  by  means  of  the  reinvestment  of  earnings,  rather 
than  by  the  issue  of  additional  securities,  is  easier  for  industrial, 
insurance,  and  banking  companies  than  for  railroads  and  other 
public  utilities.  The  rate  of  turnover  of  the  capital  is  so  much 
greater,  and  the  proportion  of  fixed  investment  to  the  total 
gross  business  so  much  smaller,  that  the  industrial  can  "finance 
itself  under  ordinary  circumstances.  This  explains  why  great 
industrial  enterprises  like  the  United  States  Steel  Corporation 
are  able  to  grow  with  such  rapidity  without  increasing  their 
bonds  and  stock  appreciably,  and  why  great  railroads  like  the 
Pennsylvania  are  forever  putting  out  new  issues  of  securities. 
It  is  not  so  much  a  diflference  in  fundamental  financial  policy, 
as  it  is  a  difiference  in  the  nature  of  the  business. 

Short-Term  Borrowing. — Temporary  financing  may  be 
based  upon  two  different  financial  presumptions.  In  one  case 
the  directors  of  the  corporation  may  issue  the  short-term  notes 
in  order  to  pay  for  extensions  and  improvements  in  structures 
and  other  permanent  or  fixed  property,  on  the  assumption  that 


266  CORPORATION  FINANCE  [XXII 

the  market  for  bonds  will  be  better  when  the  notes  mature  than 
at  the  time  of  issue. 

The  policy  of  issuing  notes  in  anticipation  of  the  issue  of 
permanent  long-term  bonds  is  of  comparatively  recent  origin. 
Prior  to  1900  it  was  the  custom  of  all  large  corporations, 
particularly  railroads,  to  anticipate  their  capital  needs  and  sell 
bonds  or  stocks  before  the  money  was  actually  needed. 

But  aside  from  the  fact  that  the  use  of  short-term  notes 
has  been  expensive,  their  issue  is  fundamentally  wrong.  A 
quickly  maturing  note  should  be  given  for  the  purchase  of 
property  only  when  the  property  is  "self -liquidating."  This 
implies  that  the  ultimate  sale  of  the  property  affords  in  itself 
the  means  of  meeting  the  notes  when  due.  The  bridge  of  a 
railroad,  the  new  warehouse  of  a  factory,  the  new  turbine  of 
an  electric  company,  will  not  do  this.  Given  a  period  of  years, 
the  presence  of  the  bridge,  the  warehouse,  the  turbine  will  so 
increase  the  earning  capacity  of  the  corporation  that  uses  it 
that  the  latter  will  be  able  to  set  aside  annually  a  fund  tc 
pay  for  the  structure  years  hence.  This  is  the  justification, 
and  the  only  justification,  for  the  purchase  of  fixed  equipment 
through  the  sale  of  long-term  bonds.  But  it  affords  absolutely 
no  justification  for  the  purchase  of  equipment  by  the  sale  of 
short-term  notes. 

Distinction  Between  Self-Liquidating  and  Fixed  Property. 
— A  very  important  principle  of  business  policy  is  evidenced 
by  this  distinction  between  self-liquidating  and  fixed  property. 
It  applies  to  the  method  of  financing  all  purchases  of  material 
required  by  an  expanding  business.  In  general,  a  business 
buys  two  kinds  of  property  as  it  expands — more  raw  materials 
and  merchandise  to  be  manufactured  or  redistributed,  and 
more  structures  and  equipment  with  which  to  carry  on  its 
enlarged  business.  The  raw  materials  and  merchandise  are 
sold  within  a  comparatively  short  time  and  if  the  business 


XXII  ]      FINANCING  EXTENSIONS  FROM  THE  PUBLIC  267 

is  sound  a  profit  will  be  realized  through  handling  it.  Ob- 
viously the  amount  and  the  cost  of  these  merchandise  pur- 
chases will  fluctuate  according  to  the  customers'  demands  for 
the  finished  product.  Even  in  a  business  requiring  a  very 
long  time  for  the  "conversion"  of  its  material,  there  will  be, 
necessarily,  a  fairly  accurate  correspondence  between  the 
amount  of  the  inventories  carried  and  the  relative  demand  for 
the  finished  product.  During  periods  of  marked  demand — 
business  booms — the  purchases  of  raw  materials  and  mer- 
chandise will  be  large.  And,  conversely,  during  periods  of 
restricted  demand — business  depressions — the  purchases  of  raw 
material  and  merchandise  will  be  small.  Obviously  the  shorter 
the  period  required  for  "conversion"  or  "turning  the  stock" 
the  quicker  will  be  the  response  and  the  more  exactly  will  the 
amount  of  the  purchases  correspond  with  the  amount  of  the 
sales.  But  even  in  businesses  requiring  long  periods  for  "con- 
version" there  is  a  definite  and  approximately  accurate  cor- 
respondence. 

The  other  types  of  purchases  made  by  an  expanding  business 
are  structures  and  equipment.  These  are  not  resold.  They  are 
incorporated,  as  soon  as  acquired,  into  the  fixed  and  permanent 
capital  of  the  business.  They  cannot  be  contracted  during 
periods  of  depression.  They  are  definitely  and  finally  per- 
manent. Once  having  been  acquired,  the  structures  and  equip- 
ment of  a  business  bear  no  relation  whatever  to  the  volume  of 
business,  nor  do  variations  in  the  volume  of  business  react 
back  on  the  amount  and  cost  of  the  structures  and  equipment. 

Financing  Self-Liquidating  Property. — The  sale  of  raw 
materials  in  a  finished  state  and  the  resale  of  merchandise  brings 
back  into  the  corporation's  treasury  at  least  as  much  and  prob- 
ably more  than  the  raw  materials  or  merchandise  cost.  This 
cost  may  therefore  be  fully  met  by  the  sale  of  notes,  on  the 
reasonable  assumption  that  the  money  with  which  to  pay  the 


268  CORPORATION  FINANCE  [  XXII 

notes  can  be  realized  from  the  sale  of  the  finished  products 
Notes  serve,  therefore,  merely  as  a  means  for  enabling  a  cor- 
poration  to  carry  a  larger  stock  of  raw  material,  goods  in  the 
process  of  manufacture,  or  merchandise  in  the  process  of  being 
distributed.  As  the  demand  for  the  finished  products  expands, 
the  raw  materials  or  merchandise  that  must  be  purchased  ex- 
pand proportionately;  and  with  the  increased  stock  of  goods 
more  money  must  be  tied  up  in  the  inventories.  This  can  best 
be  obtained  by  temporary  borrowings.  The  notes  should  be 
arranged  to  mature  at  about  the  time  the  corporation  would 
reasonably  expect  to  receive  payment  for  the  finished  goods. 
This  will  represent  the  time  required  to  manufacture  and  dis- 
tribute the  goods,  the  average  period  that  finished  goods 
remain  in  stock  before  their  sale,  together  with  the  time 
ordinarily  required  to  collect  the  account  from  the  customer. 
Clearly,  each  of  these  three  factors  will  vary  with  the  technique 
and  the  customs  of  the  industry,  but  gross  averages  within  a 
single  industry  can  be  determined  beforehand  with  a  fair 
degree  of  accuracy.  The  important  and  vital  fact  is  that  the 
volume  of  outstanding  notes  can  be  made  to  fluctuate  directly 
with  the  volume  of  the  inventories.  One  is  the  obverse  of  the 
other.  With  the  sale  of  notes,  inventories  are  acquired;  with 
the  sale  of  the  inventories  the  notes  are  paid. 

Financing  Fixed  Property. — Permanent  improvements  are 
not  resold  to  liquidate  the  obligations  which  paid  for  them. 
These  obligations  can  be  paid  for  only  through  the  increased 
earnings  of  the  corporation;  the  increased  earnings  should  be 
sufficient  at  least  to  meet  the  interest  on  these  obligations  and 
to  amortize,  by  means  of  a  sinking  fund,  the  improvements 
before  they  are  worn  out  or  become  obsolete.  If  improve- 
ments are  made  wisely  the  business  will  show  exactly  these 
results,  and  ultimately  this  gradually  accumulating  fund  may 
be  used  to  pay  the  obligations  incurred  in  acquiring  the  im- 


XXII  ]      FINANCING  EXTENSIONS  FROM  THE  PUBLIC  269 

provements.  Obviously  these  obligations  must  run  for  many 
years ;  they  must  be  represented  either  by  stock  or  by  a  funded 
debt  that  matures  after  an  interval  long  enough  to  allow 
of  sufficient  accumulations  in  the  fund  to  meet  the  debt.  Per- 
manent improvements  should  be  paid  for  from  the  proceeds 
of  the  sale  of  stock  or  long-term  bonds. 

But  the  question  of  whether  bonds  or  stocks  should  be 
sold  to  pay  for  permanent  improvements  is  not  so  easily 
answered.  If  it  seems  expedient  for  the  corporation  to  sell 
bonds,  the  further  question  arises  whether  they  should  be  of 
short  or  long  maturity,  and  the  character  of  the  bonds  best 
suited  to  the  particular  circumstances.  If  on  the  other  hand, 
it  seems  expedient  to  issue  stock,  it  must  be  decided  whether 
the  shares  shall  be  common  or  preferred.  In  any  case  the 
directors  of  a  corporation  seeking  capital  for  expansion  must 
decide  wdiether  the  new  securities  shall  be  sold  to  independent 
bankers  or  to  stockholders.  To  consider  these  questions  aright, 
it  is  necessary  to  consider  first  certain  general  advantages 
pertaining  to  each  class  of  security,  and  apply  the  principles 
of  such  an  inquiry  to  different  types  of  corporations. 

Advantages  of  Selling  Bonds. — There  are  certain  specific 
advantages  which  the  issue  of  bonds  affords,  not  ordinarily 
possessed  by  a  new  issue  of  stock.  The  most  apparent  is  the 
lower  rate  at  which  the  new  capital  for  expansions  may  be 
secured  through  bond  issues  rather  than  stock  issues.  A  bond 
security  is  stronger  than  a  stock,  so  that  the  ultimate  com- 
pensation for  the  risk  which  the  investor  will  demand  is  cor- 
respondingly less.  But  in  addition  to  this  is  the  fact  that  the 
market  for  considerable  amounts  of  bonds  of  established 
enterprises  is  wider  than  for  a  large  new  issue  of  stock.  Con- 
sequently the  cost  of  merchandising  is  less. 

Aside  from  economy  of  issue,  bonds  would  permit  a  con- 
tinuation of  a  concentration  of  control.    Stock  would  ordinal  i^y 


?70  CORPORATION  FINANCE  [XXII 

be  granted  voting  power,  and  as  the  corporation  grew  in  size 
the  new  stockholders  might  very  easily  outnumber  the  old. 
The  proprietors  might  well  take  the  position  that  it  were  better 
to  continue  their  old  business  within  small  compass  than  to 
extend  it  through  the  capital  furnished  by  a  group  of  outsiders 
possessing  a  right  to  interfere  with  the  established  order. 

Still  another  advantage  to  be  gained  by  selling  bonds, 
rather  than  stocks,  is  the  comparatively  large  blocks  of  an 
issue  that  can  be  sold  to  a  single  customer,  thus  reducing 
considerably,  for  either  the  corporation  or  the  bankers,  the 
actual  expense  of  distribution.  It  is  exceedingly  difficult  to 
place  large  amounts  of  stock  except  among  the  directors  or 
their  associates,  because  no  man  would  desire  to  become  a 
heavy  stockholder  in  a  corporation  with  its  attendant  risks, 
without  securing  some  voice  in  the  management.  But  life 
and  other  insurance  companies,  banks,  trustees  of  private 
funds,  the  treasurers  of  religious  and  eleemosynary  corpora- 
tions, stand  ready  to  absorb  large  amounts  of  bonds  without 
requiring  at  the  same  time  a  voice  in  the  management. 

Advantages  of  Issuing  Stock. — On  the  other  hand  there 
are  many  types  of  corporations  which  cannot  wisely  issue  bonds 
and  are  confined  in  all  their  financial  operations  to  stock  issues. 
Such  corporations  include  banks,  insurance  companies,  and 
manufacturing  companies  situated  in  states  which  discrimi- 
nate in  their  tax  laws  against  investments  in  bonds.  Other 
corporate  enterprises,  such  as  mines,  patented  inventions,  retail 
stores,  and  the  like,  would  wisely  do  all  their  financing  by 
means  of  stocks,  although  there  are  no  laws  that  prohibit  the 
issue  of  bonds,  were  it  possible  to  sell  them. 

The  payment  of  the  costs  of  the  expansion  of  a  corpora- 
tion by  means  of  the  sale  of  new  stock  issues  even  when  bond 
issues  are  possible,  has  besides  certain  very  positive  advantages 
over  expansion  by  means  of  bonds.     The  greatest  of  these 


XXII  \      FINANCING  EXTENSIONS  FROM  THE  PUBLIC  27 1 

is  that  stock  carries  no  irrevocable  promise  of  dividend  pay- 
ment. The  payment  of  interest  on  a  bond  is  fixed  and  the 
failure  to  pay  it  precipitates  failure.  Most  corporation 
directors,  no  matter  how  successful  the  enterprise  may  be, 
hesitate  to  burden  it  with  fixed  charges,  even  if  the  future 
gives  promise  of  earnings  that  exceed  the  charges  many 
times  over. 

At  no  time  in  the  company's  history  do  the  credit  man  and 
the  banker  watch  a  company's  general  credit  more  carefully 
than  when  a  small  business  is  expanding  into  a  large  one.  The 
old-established  lines  of  credit  must  be  increased;  the  limit  of 
bank  loans  must  be  raised.  Otherwise  the  business  cannot 
carry  its  enlarged  inventories  and  accounts  receivable.  Just 
at  this  critical  time  the  issue  of  bonds  to  meet  the  increases  in 
the  plant  account  would  hurt,  distinctly,  the  public  credit.  The 
bankers  and  merchandise  creditors  would  naturally  assume  that 
the  policy  was  prompted  by  one  of  several  reasons :  either  the 
directors  had  not  enough  financial  backing  among  the  stock- 
holders to  secure  new  money  from  the  sale  of  stock,  or  them- 
selves lacked  confidence  in  the  enterprise,  preferring  to  risk 
other  people's  money  rather  than  their  own,  or  else  that  they 
proposed  to  follow  a  different  and  more  audacious  plan  of 
financing,  the  success,  even  the  expediency,  of  which  could  not 
be  foretold  from  the  past.  Any  one  of  these  inferences  would 
destroy  the  general  credit  of  the  expanding  corporation 
irrespective  of  the  margin  of  current  assets  over  current 
liabilities.  On  the  other  hand,  if  the  directors  sell  to  the  pu1)lic 
an  issue  of  stock,  the  proceeds  of  which  are  used  to  extend  the 
plant,  to  pay  ofif  maturing  loans,  and  to  increase  the  excess  of 
current  assets  over  current  liabilities,  the  power  of  the  cor- 
poration to  sell  its  notes  and  acceptances  will  be  enormously 
increased.  From  the  bankers'  point  of  view  their  equity  has 
been  increased  by  the  full  extent  of  the  new  capital  brought 
into  the  business. 


272  CORPORATION  FINANCE  (  XXII 

Application  of  Principles  to  Different  Businesses. — These 
principles  do  not  apply  with  equal  force  to  all  types  of  cor- 
porate enterprises.  They  have  the  greatest  strength  for  in- 
dustrials and  the  least  for  local  utilities.  An  industrial  must 
borrow  heavily  at  banks  in  order  to  carry  its  inventories  and 
receivables.  Its  earnings  are  not  easily  predicted,  nor  can  it 
fortify  itself  against  sudden  changes  in  the  demand  for  its 
product,  against  labor  disturbances,  and  against  unusual 
stupidity  in  management.  These  unpredictable  elements  are 
less  in  evidence  in  a  local  utility,  although  even  here  too  much 
confidence  cannot  be  placed  on  the  assurance  of  increased  earn- 
ing power  in  which  both  the  public  service  company  operators 
and  the  bond-buyers  place  their  trust.  It  is  interesting  to  note 
also  that  small  investors  are  as  a  rule  unfamiliar  with  bonds, 
so  that  a  corporation  can  secure  a  much  wider  market  among 
small  investors  through  the  sale  of  stock  than  it  can  through 
bonds. 

Advantages  of  Sale  to  Bankers — In  all  probability  the 
decision  of  the  directors  of  a  corporation  as  to  whether  they 
shall  pay  for  extensions  by  the  issue  of  bonds  or  of  stock 
cannot  be  made  without  taking  into  consideration  the  means  to 
be  employed  in  selling  the  new  securities.  Two  distinct  means 
are  available.  The  corporation  directors  may  either  sell  the 
entire  issue  directly  to  bankers,  or  they  may  offer  the  securities 
to  the  stockholders  in  the  proportion  of  stockholdings. 

I.  Assurance  of  Sales. — Perhaps  the  foremost  advantage 
of  the  sale  of  the  entire  issue  of  new  securities  to  investment 
bankers  is  the  assurance  of  a  successful  sale.  Ordinarily  the 
management  of  a  corporation  spends  money  for  improvements 
before  the  money  is  actually  in  hand.  A  floating  debt  is  in- 
curred which  it  is  proposed  to  fund  by  means  of  the  money 
obtained  from  the  sale  of  the  new  securities.     Ordinarily,  too, 


XXII  ]      FINANCING  EXTENSIONS  FROM  THE  PUBLIC  273 

the  payment  of  the  bank  loans  representing  these  floating  debts 
must  be  met  in  the  immecHate  future ;  and  the  improvements 
themselves  must  be  carried  through  once  they  are  commenced. 
It  is  therefore  imperative  that  the  corporation  obtain  the  money 
its  plans  call  for ;  these  cannot  depend  on  the  temporary  fancy 
of  stockholders  nor  be  jeopardized  by  the  kaleidoscopic 
changes  of  the  financial  markets.  Ordinarily,  therefore,  the 
corporation  is  very  glad  to  allow  the  bankers  to  assume  these 
risks,  even  though  a  slightly  less  price  is  realized  than  if  the 
bonds  or  stocks  were  sold  directly  to  the  final  investors.  It 
is  this  assurance  of  the  immediate  payment  of  money  that 
ordinarily  leads  to  the  acceptance  of  the  definite  offer  from 
the  bankers,  the  more  conservative  of  the  directors  preferring 
to  run  no  risks  of  being  caught  in  the  meshes  of  an  unfavor- 
able credit  market. 

2.  Establishment  of  a  Protective  Alliance. — While  the 
relationship  between  investment  bankers  and  the  corporations 
for  which  they  have  once  sold  securities  may  not  require  the 
bankers  to  underwrite  every  issue  that  the  corporation  may 
thereafter  bring  out,  still  the  fact  that  the  bankers  have  once 
investigated  the  enterprise  and  decided  to  lend  their  support 
in  financing  it  implies  a  willingness  to  assume  at  least  a  favor- 
able attitude  toward  future  issues  of  securities.  In  fact,  it  is 
one  of  the  unwritten  laws  of  investment  banking  that  when 
a  banker  has  once  established  intimate  association  with  a 
corporation  he  shall  have  at  least  the  first  opportunity  of 
bringing  out  subsequent  issues.  Sometimes  this  closeness  of 
connection  works  greatly  to  the  advantage  of  the  corpora- 
tions, as  it  protects  them  during  periods  of  financial  stress, 
when  capital  is  difficult  to  obtain  at  any  price,  from  lieing 
handicapped  in  financing  improvements  or  in  refunding  old 
issues  of  securities.  For  it  is  clear  that  if  bankers  have  been 
responsible  for  the  wide  distribution  of  a  company's  securities 


274  CORPORATION  FINANCE  [XXII 

in  the  past,  they  will  acknowledge  an  obligation  to  protect  the 
company  in  an  emergency  so  that  the  value  of  the  securities 
already  sold  shall  not  be  jeopardized.  Corporations  have  in 
several  important  instances  actually  passed  into  the  hands  of 
receivers,  for  the  reason  that  their  managers  had  in  the  past 
failed  to  effect  a  strong  alliance  with  investment  bankers. 

3.  Widening  the  Market  for  Securities. — Expansion 
through  the  sale  of  securities  to  bankers  widens  the  market 
for  the  company's  securities  in  a  manner  not  possible  through 
the  sale  of  either  bonds  or  stock  to  the  old  stockholders,  and 
the  wider  the  market  for  the  company's  securities  the  more 
secure  it  is  in  the  control  over  new  capital. 

Small  additions  of  capital  may  be  obtained  from  time  to 
time  from  the  old  stockholders,  but  ordinarily  large  increases 
of  capital  must  be  sought  in  the  general  investment  market. 
A  failure  to  acknowledge  this  principle  was  one  of  the  early 
difficulties  with  the  financing  of  the  American  Telephone 
and  Telegraph  Company.  Finding  it  comparatively  easy  to 
sell  large  blocks  of  stock  directly  to  stockholders,  the  directors 
resorted  to  this  method  of  expansion  continuously,  during  all 
the  earlier  years  of  the  company's  growth  while  the  Bell 
Telephone  system  was  being  extended  throughout  the  United 
States.  Meanwhile,  the  individual  stockholdings,  although 
growing  in  size,  were  being  concentrated  in  one  geographical 
area  where  the  early  stockholders  resided.  But  the  demands 
for  expansion  grew  faster  than  the  savings  capacity  of  the 
stockholders,  or  rather  than  that  portion  of  their  savings 
which  they  cared  to  invest  in  telephone  securities.  As  a  result 
the  management  experienced  a  constantly  growing  difficulty 
in  finding  a  fair  market  for  the  new  stock  allotments  as  they 
were  successively  issued.  This  destroyed  the  real  market  for 
the  stock  of  the  American  Telephone  and  Telegraph  Company 
and  reduced  its  market  price  below  its  true  value,  with  respect 


XXII  ]       FINANCING  EXTENSIONS  FROM  THE  PUBLIC  275 

to  Other  securities  of  equal  intrinsic  value,  but  possessing  a 
wider  market.  In  1906  a  new  management,  realizing  that 
the  fundamental  financial  difficulty  of  the  telephone  industry 
was  its  continual  requirements  for  new  capital,  sought  to 
extend  the  market  for  its  shares  from  Boston  to  New  York 
in  the  hope  of  securing  a  national,  and  later  an  international, 
market  for  its  securities.  The  effort  was  partially  successful, 
although  it  did  not  occur  early  enough  to  give  the  company 
the  nationwide  investment  interest  that  its  enormous  expan- 
sion of  the  succeeding  ten  years  required.  What  has  proved 
true  to  a  large  extent  with  the  telephone  company  has  been 
shown  to  a  lesser  degree  by  the  Pennsylvania  Railroad. 

Relative  Economy. — Another  advantage,  particularly  to 
the  issuing  corporation  of  an  established  reputation,  is  the 
simple  fact  that  there  are  a  great  many  dififerent  investment 
bankers  and  competition  among  them  permits  the  corporation 
to  obtain  the  highest  price  for  its  new  securities  which  the 
general  investment  market  permits.  The  business  of  selling 
securities  is  a  highly  competitive  one;  yet  the  profits  of  the 
business,  if  managed  ably,  are  very  large.  Bankers  long  ago 
recognized  that  it  is  far  better  policy  to  purchase  the  issues  of 
old,  long-established,  and  profitable  companies,  even  though 
their  gross  profit  on  each  sale  is  small,  than  the  issues  of  new 
corporations  where  the  chance  of  a  mistake  in  judgment  is 
greater,  and  therefore  the  risk  to  their  reputation  is  a  matter 
of  serious  consideration.  So  it  is  not,  with  a  successful  cor- 
poration, a  difficult  problem  to  find  a  banker ;  the  obstacle 
usually  met  with  is  that  of  inducing  the  banker  to  sell  the 
issue  on  a  sufficiently  narrow  margin  of  profit.  For  example, 
the  New  England  Telephone  and  Telegraph  sold  in  1912  an 
issue  of  $10,000,000  5  per  cent  debenture  bonds.  The  bankers 
received  only  one-half  of  i  per  cent  commission.  This  was  an 
exceptionally  low  margin.     Little  advertising  on  the  part  of 


276  CORPORATION  FINANCE  [XXII 

the  bankers  was  necessary  and  the  bonds  were  sold  within 
a  few  hours  of  the  opening  of  the  subscription  books.  It  is 
true  that  few  large  bond  sales  can  be  completed  on  as  cheap  a 
basis  as  this,  but  ordinarily  the  cost  to  an  old-established  cor- 
poration with  assured  earning  power  did  not  exceed  2^  per 
cent  of  the  amount  actually  paid  by  the  public  purchasers  in 
the  period  before  the  Great  War.  Since  191 5,  however,  the 
bankers'  commissions,  or  their  margin  of  profit,  have  grown 
steadily  larger.  With  the  increasing  difficulty  experienced  in 
placing  securities,  as  a  result  of  the  worldwide  scarcity  of 
capital,  bankers  possessing  an  assured  distributing  capacity  have 
been  in  a  strategic  position  as  compared  with  corporations 
facing  the  necessity  of  selling  bonds.  While  the  highest  grade 
bonds  issued  by  corporations  with  very  high  credit  were  sought 
after  by  bankers  to  a  limited  extent,  the  commissions  they 
demanded  were  often  larger  than  what  they  obtained  for  the 
sale  of  medium  and  low-grade  bonds  before  the  war. 

In  some  too  frequent  cases  the  corporation  has  had  its 
hands  tied  by  the  influence  on  the  board  of  directors  of  some 
prominent  banking  house  which  secures  the  new  issue  under 
conditions  which  prohibit  competitive  bidding.  Without  for 
the  moment  underestimating  the  value  to  any  corporation  of 
the  constant  assistance  and  advice,  not  to  speak  of  the  financial 
support,  of  prominent  bankers,  it  is  necessary  to  acknowledge 
that  no  man  may  act  as  buyer  for  himself  and  seller  for  the 
stockholders,  for  whom,  as  director,  he  is  trustee.  It  may  be 
true  that  the  banker  is  indirectly  paid  for  innumerable  services 
not  specifically  accounted  for  by  the  low  price  at  which  he  is 
able  to  buy  the  bonds.  But  he  is  truer  to  the  principles  of  his 
trusteeship  if  he  insists  on  paying  the  full  competitive  price 
for  the  bonds,  and  then  requires  of  the  corporation  specific  pay- 
ment for  specific  services  rendered. 


CHAPTER  XXTII 

NEW  CAPITAL  FROM  SALES  OF  STOCK- 
PARTICULARLY  TO  STOCKHOLDERS 

Offerings  of  Preferred  Stock  by  Bankers. — Prior  to  the 
Great  War  it  was  the  common  custom  for  successful  expanding 
corporations  to  sell  bonds  to  bankers  and  stock  to  their  own 
stockholders.  But  since  the  beginning  of  the  Great  War 
this  sequence  has  ceased  to  have  much  of  its  old  significance. 
Bankers  are  now  increasingly  employed  to  distribute  preferred 
and  common  shares  for  the  purpose  of  financing  extensions, 
and  they  are  forgetting  much  of  their  old-time  insistence  that 
the  securities  they  distribute  to  investors  shall  have  the  strength 
and  stability  of  bonds. 

The  first  of  the  causes  of  the  shift  of  bankers'  purchases 
from  bonds  to  stocks  is  the  demand  of  what  might  be  called 
the  "new'  investors"  for  large  income  return.  This  class  in- 
cludes men  who,  because  of  abnormally  high  wages  or  inordi- 
nate profits  during  and  following  the  Great  War,  had  money 
for  investment  for  the  first  time.  They  were  ignorant  of  the 
distinction  between  stock  and  bond,  and  the  legal  and  economic 
barriers  that  separate  the  partner  from  the  creditor  of  a  busi- 
ness enterprise.  They  were  therefore  easily  deluded  into  buy- 
ing preferred  stocks  of  industrial  enterprises  because  of  their 
greater  apparent  yield.  Then,  too,  this  same  argument 
appeals  strongly  to  the  more  conservative  investors  of  the 
community  who  find  that  the  rising  level  of  commodity  prices 
renders  it  necessary  to  obtain  a  higher  net  return  on  their  in- 
vestments. Present  necessities  color  and  befog  their  judg- 
ments  of   the  permanent   and   intrinsic  values   of   securities. 

Another  and  perhaps  more  important  explanation  of  the 

277 


278  CORPORATION  FINANCE  [XXIII 

increased  offerings  by  bankers  of  preferred  stocks  is  the  great 
prosperity  of  manufacturing  establishments  since  the  opening 
of  the  Great  War,  as  compared  with  the  raihoad,  local  public 
utility,  and  traction  industries.  Whereas  railroads  and  public 
utilities  frequently  issue  bonds  for  the  purpose  of  expansion, 
industrials  rely  to  a  greater  extent  upon  the  issue  of  stock. 
In  consequence,  bankers  showed  no  hesitancy  in  directing  the 
attention  of  their  customers  to  the  advantages  of  stocks,  and 
the  customers  fell  easily  into  believing  these  advantages  sound 
and  permanent. 

But  probably  the  deepest  reason  for  this  change  was  a 
change  in  the  attitude  of  the  bankers  themselves.  Their 
judgment  became  befogged  by  the  lure  of  the  long  profit.  The 
banker's  margin  of  gross  profit  on  stocks,  both  preferred  and 
common,  has  always  been  higher  than  that  on  bonds.  In  addi- 
tion to  the  merchandising  profit  on  the  preferred  stock,  there 
is  usually  a  surreptitious  bonus  of  common  stock. 

Preferred  Stocks  as  Substitutes  for  Bonds. — With  the 
growing  use  of  preferred  stocks  as  a  substitute  for  bonds  in 
obtaining  capital  from  the  public  to  pay  for  extensions,  there 
has  been  a  conscious  and  studied  effort  on  the  part  of  bankers 
to  give  these  issues  the  appearance  of  bond  security.  Ad- 
vantageous as  the  issue  of  a  preferred  stock  may  be  to  the 
expanding  corporation,  the  value  of  these  pretended  safeguards 
must  be  weighed  from  the  point  of  view  of  the  investor. 
Especially  is  this  true  since  these  recent  preferred  stocks  have 
sought  to  obliterate  the  distinction  between  creditor  and 
partner,  seeking  to  retain  certain  of  the  outward  characteristics 
that  belong  to  stocks,  while  they  grasp  for  the  strength  and 
security — the  substance,  as  it  were — that  goes  with  bonds. 
These  efforts  have  proved  only  partially  successful  for  the 
simple  reason  that  preferred  shares,  however  named  and  how- 
ever hedged  in  by  covenants,  cannot  be  given  a  priority  in  case 


XXIII  ]  NEW  CAPITAL  FROM  SALES  OF  STOCK  279 

of  the  failure  of  the  enterprise.  This  is  the  real  substance  of 
mortgage  bonds,  a  substance  which  modern  reorganization 
procedure  has  somewhat  weakened  it  is  true,  but  a  substance 
which  gives  the  bond  the  priority  not  only  over  the  stocks  but 
also  over  most  of  the  notes  and  current  obligations. 

Probably  the  feature  of  the  recent  issues  of  preferred 
stocks  that  is  in  most  striking  contrast  to  the  older  issues, 
especially  those  created  at  the  time  of  the  reorganization  or 
promotion  of  a  corporation,  is  the  provision  requiring  the 
gradual  retirement  of  the  preferred  stock.  This  is  usually 
called  the  "sinking  fund,"  from  a  seeming  analogy  to  the 
sinking  fund  provision  of  bond  issues.  Such  a  provision  was 
practically  unknown  in  preferred  stock  issues  down  to  1910; 
it  occurred  with  increasing  frequency  during  the  period  of 
the  Great  War,  and  has  been  well-nigh  universal  among  pre- 
ferred stock  issues  since  the  Armistice.  Besides  constantly 
decreasing  the  proportion  of  preferred  stock  liability  standing 
against  the  available  assets,  such  a  retirement  fund  provision 
stimulates  a  market  for  the  preferred  stock  in  so  far  as  the 
company  itself  is  forced  to  purchase  each  year  some  of  the 
stock.  This  is  especially  important  to  the  investor  in  small 
issues  of  preferred  stock  which  would  have,  under  ordinary  cir- 
cumstances, a  limited  and  narrow  market.  The  annual  retire- 
ment fund  of  these  modern  preferred  stocks  is  determined  by 
one  of  three  provisions — a  percentage  of  the  net  earnings, 
a  percentage  of  the  outstanding  preferred  stock,  or  a  definite 
par  value  of  stock. 

Sale  of  Common  Stock  to  Stockholders — Requirements. — 
When  a  corporation  wishes  to  sell  common  stock,  the  directors 
themselves,  rather  than  bankers,  will  probably  try  to  sell  the 
stock,  especially  if  the  corporation  has  been  established  a  con- 
siderable period  of  time  and  has  a  loyal  group  of  stockholders. 
"Privileged  subscription"  is  the  term  used  to  refer  to  the  offer 


280  CORPORATION  FINANCE  [  XXIIl 

by  a  corporation  to  sell  a  new  security,  usually  stock,  to  its 
stockholders  for  less  than  the  current  market  value.  It  is 
only  by  the  special  inducement  of  a  low  price  that  a  corporation 
can  be  sure  of  securing  capital  from  its  own  stockholders,  for 
the  loyalty  of  the  great  body  of  stockholders  today  to  their  cor- 
poration does  not  extend  to  making  pecuniary  sacrifices ;  there 
must  be  the  compulsion  of  permanent  self-interest. 

In  order  that  an  issue  of  stock  may  be  successfully  sold 
to  stockholders,  the  corporation  must  meet  at  least  three  essen- 
tially different  conditions.  These  conditions,  it  should  be  noted, 
are  of  the  utmost  importance,  because  they  define  a  set  of 
practical  tests  to  determine  whether  or  not,  in  a  given  case,  a 
sale  of  stock  to  stockholders  is  likely  to  be  successful. 

Market  Value  of  Old  Stock.  Most  important  of  all  is  the 
price  at  which  the  old  stock  is  selling  at  the  time  the  new  is 
offered.  In  order  that  the  stock  may  be  taken  by  the  old 
stockholders,  the  market  price  of  the  outstanding  stock  must 
be  well  above  the  price  at  which  the  new  stock  is  offered. 
Ordinarily  the  new  stock  is  offered  at  par.  Unless,  therefore, 
the  market  price  of  the  old  stock  is  above  par,  stockholders 
will  not  take  the  new.  On  the  other  hand,  if  the  corporation 
is  very  successful  and  its  shares  are  valued  highly  by  investors 
it  may  be  sure  that  an  offering  to  its  stockholders  will  be 
highly  prized,  and  that  the  "rights,"  so-called,  which  enable 
the  stockholder  to  buy  the  stock  at  less  than  its  customary 
market  value,  will  command  a  liberal  price  on  the  open 
market. 

Widely  Held  Stock.  The  second  requirement  of  a  suc- 
cessful sale  of  new  stock  to  stockholders  is  that  the  old  stock 
shall  be  widely  held  by  stockholders.  This  is  much  more  im- 
portant than  would  appear  at  first  sight,  for  it  might  be  pre- 
sumed that  the  size  of  a  man's  holdings  would  have  little  to  do 
with  either  his  willingness  or  his  capacity  to  take  up  his  allotted 
stock,  yet  the  mere  fact  that  the  corporation  has  a  very  large 


XXIII  ]  NEW  CAPITAL  FROM  SALES  OF  STOCK  28l 

number  of  shareholders  increases  the  possibiHty  of  a  successful 
sale,  because  the  failure  of  a  few  to  buy  their  proportional 
shares  does  not  jeopardize  the  whole  subscription.  Nor  is  it 
correct  to  assume  that  the  size  of  a  man's  holdings  is  immaterial 
to  his  capacity  for  acquiring  new  stock.  When,  therefore,  the 
new  stock  is  offered  for  subscription,  the  large  stockholders  will 
conclude  that  the  comparatively  heavy  increase  in  their  holdings 
of  this  particular  security  is  contrary  to  some  preconceived 
plan  of  distribution.  The  small  stockholder,  on  the  contrary, 
will  seldom  be  influenced  by  theories  of  the  proper  diversifica- 
tion of  his  investment  holdings  but  will  base  his  decision  as 
to  whether  he  will  subscribe  to  the  stock  or  sell  his  rights  solely 
on  the  availability  of  sufficient  funds. 

Justified  Extensions.  The  third  condition  essential  to  a 
successful  sale  of  new  stock  to  the  old  stockholders  is  that  the 
directors  of  the  corporation  shall  fully  justify  the  extensions 
to  be  made  with  the  new  capital.  This  requires  that  the 
directors  shall  take  the  stockholders  into  their  confidence  with 
the  utmost  frankness.  There  have  been  exceptions  to  this 
simple  and  wholesome  rule.  The  directors  of  the  New  York, 
New  Haven  and  Hartford  Railroad  during  the  period  of  its 
notorious  overexpansion  had  only  to  "ring  the  bell"  (to  use 
a  Wall  Street  phrase),  when  the  stockholders  would  rush  for- 
ward with  subscriptions  to  any  amount  the  management  might 
ask  for. 

An  excellent  example  of  frankness  on  the  part  of  a  cor- 
poration toward  its  stockholders  is  afiforded  by  the  circular  of 
the  New  York  Central  Railroad  Company  offering  them  the 
privilege  of  subscribing  to  its  6  per  cent  Convertible  Debentures 
of  1935-  The  whole  circular  is  a  model  of  its  kind.  After 
stating  in  brief  the  conditions  of  subscription,  the  circular 
states,  in  part : 

The  proceeds  of  the  sale  of  the  bonds  will  be  used  to  fund  an 
equal  amount  of  the  company's  now  unfunded  debt  which  has 


282  CORPORATION  FINANCE  [XXIII 

been  incurred  for  the  betterment  and  extension  of  its  railroads, 
and  in  the  acquisition  of  property. 

The  convertible  bonds  will  carry  an  interest  charge  sub- 
stantially the  same  as  heretofore  paid  on  notes  to  be  funded. 

The  more  important  improvements  made  on  the  lines  now 
comprising  the  New  York  Central  Railroad  since  January  i, 
1910,  include : 

Further  construction  at  the  Grand  Central  Terminal,  at  a 
cost  of  $30,000,000  (including  commercial  buildings),  in 
order  to  meet  the  requirements  of  an  increasing  pas- 
senger business,  and  to  develop  the  valuable  real  estate 
within  the  terminal  area.  The  annual  rentals  received 
from  the  Grand  Central  Terminal  amount  to  more  than 
$2,000,000,  which  should  increase  as  further  improve- 
ments are  completed  and  become  productive. 

Acquisition  of  important  links  in  the  company's  main  line 
previously  held  on  lease,  $14,185,000. 

Four-tracking  between  New  York  and  Albany,  including 
improved  signaling  and  new  stations,  $15,931,000. 

New  passenger  stations  at  Rochester  and  at  Utica,  includ- 
ing new  engine  terminals,  new  yards  and  appurtenances, 
$6,886,000. 

Elimination  of  grade  crossings  and  enlargement  of  Gar- 
denville  yard,  $3,276,000. 

Electrification  work  between  New  York,  Croton  and 
White  Plains,  $3,783,000. 

Enlargement  and  improvement  of  facilities  west  of  Buf- 
falo, $14,000,000. 

Since  January  i,  1900,  the  New  York  Central  and  Hudson 
River  Railroad  Company,  the  Lake  Shore  and  Michigan  South- 
ern Railway  Company  and  their  subsidiaries,  now  consolidated 
into  the  New  York  Central  Railroad  Company,  increased  their 
resources  by  $658,000,000,  of  which  over  $122,000,000  came 
from  the  sale  of  capital  stock  and  over  $114,000,000  from  earn- 
ings. The  remainder  came  from  the  sale  of  bonds,  equipment 
trust  certificates,  and  notes. 

Sale  of  New  Securities  to  Stockholders. — If  the  corpora- 
tion can  meet  none  of  these  conditions  and  yet  its  directors 


XXIII  ]  NEW  CAPITAL  FROM  SALES  OF  STOCK  283 

believe  that  their  own  stockholders  afford  the  best  source  of 
new  capital,  they  may  authorize  a  new  kind  of  security,  such 
as  a  preferred  stock  or  a  debenture  bond,  to  be  sold  among 
the  stockholders.  The  Detroit  Edison  Company,  for  example, 
alternated  at  different  times  during  the  last  ten  or  fifteen  years 
between  a  debenture  offering  to  its  stockholders  and  a  new 
stock  offering.  Owing  to  the  great  earning  power  of  the 
company  and  its  excellent  management  these  privileged  sub- 
scriptions have  been  always  successful. 

Terms  of  Privileged  Subscriptions. — If  it  is  decided  by  the 
corporation  to  offer  new  stock  at  less  than  its  probable  market 
value,  the  old  stockholders  will  have  the  privilege  of  subscrib- 
ing to  the  new  stock  in  proportion  to  their  holdings.  This 
privilege  is  usually  offered  under  carefully  specified  conditions. 
The  time,  for  example,  over  which  the  right  of  subscription 
extends  is  very  carefully  defined,  although  the  period  varies 
considerably.  In  close  corporations,  where  the  privilege  is 
of  great  value,  the  directors  usually  restrict  the  offering  to 
stockholders  of  record  at  the  time  and  allow  them  only  a  short 
time  within  which  to  subscribe.  In  large  corporations  with 
widely  diversified  stockholdings  the  privilege  is  often  made  to 
apply  to  the  stockholders  of  record  some  days  after  the  vote 
and  the  period  during  which  the  new  stock  may  be  acquired 
extends  over  some  months.  Usually  the  stockholders  are 
allowed  to  pay  for  the  new  stock  in  instalments  and  interest 
is  allowed  them  on  all  payments  preceding  the  actual  delivery 
of  the  stock.  When  there  are  two  classes  of  stock  the  practice 
varies  considerably.  If  the  privilege  is  valuable  it  is  usually 
confined  to  the  controlling  common  shareholders;  if  it  is  not 
very  valuable  and  some  difficulty  is  anticipated  in  securing 
subscriptions  it  is  invariably  extended  to  both  classes  of  stock- 
holders. Instances  exist  in  which  it  has  been  extended  to  bond- 
holders. 


284  CORPORATION  FINANCE  [  XXIII 

Theoretical  Value  of  Rights. — The  specific  privilege  that 
goes  to  all  the  old  stockholders  to  subscribe  to  the  new 
security  is  called  a  "right."  Rights  are  bought  and  sold  on  the 
stock  market  in  the  same  manner  as  shares  are  bought  and 
sold.  Their  market  price  depends  on  the  relative  advantage  of 
acquiring  the  stock  of  the  corporation  by  subscription  over  the 
ordinary  purchase  in  the  open  market.  The  market  value  of 
a  right  is  determined  theoretically  with  reference  to  the  price 
of  the  old  shares.  If  r  represents  the  number  of  shares  entitled 
to  one  new  share,  s  the  subscription  price,  and  ni  the  market 
value  of  the  old  stock,  we  may  express  by  the  following  formula 
the  theoretical  value,  v,  of  a  single  right: 

m  —  s 

v= — — 
r  +  I 

For  example,  the  American  Telephone  and  Telegraph 
Company  offered  new  stock  at  120  at  the  ratio  of  one  new 
share  for  every  five  shares  already  held,  and  the  stock  was 
selling  at  the  time  of  the  announcement  at  151^  a  share. 
Then  the  theoretical  value  of  the  right  is  given  directly  by  the 
formula : 

1515^  -  120 

Many  people  assume  that  the  value  of  a  right  is  given 
directly  by  dividing  the  difference  between  the  subscription 
price  and  the  market  price  by  the  ratio.  This  is  incorrect, 
because  it  should  be  remembered  that  the  reduced  subscription 
price  of  the  new  stock  is  going  to  act  as  a  dilution  of  the  value 
of  the  premium  on  the  old  shares. 

Market  Value  of  Rights. — The  market  price  of  a  right  is 
seldom  equal  to  its  theoretical  value.    The  assumption  that  the 


XXIII  ]  NEW  CAPITAL  FROM  SALES  OF  STOCK  285 

two  are  equal  would  presume,  in  the  first  place,  that  the  sub- 
scription to  the  new  stock  through  the  medium  of  the  purchase 
of  rights  would  represent  a  cost  equivalent  to  the  stock  bought 
on  the  open  market.  Yet  the  purchase  of  the  stock  through 
the  rights  involves  more  trouble.  Most  men  therefore  would 
prefer  to  buy  the  stock  outright  on  the  market  rather  than 
through  subscription  to  the  new  stock,  unless  the  latter  method 
were  the  cheaper.  In  order  to  establish  a  free  market  for  the 
rights  they  would  have  to  be  offered  at  a  slight  concession  under 
their  theoretical  value,  even  though  there  were  no  other  reasons 
to  depress  the  value  of  the  rights.    But  there  are  other  reasons. 

There  has  always  been  among  brokers  a  feeling  that  rights 
sell  for  most  at  the  beginning  of  the  subscription  period,  and 
least  at  the  end.  This  feeling  has  amounted  to  little  more  than 
an  assumption  on  the  part  of  the  brokers,  supported  by  a  few 
examples  culled  from  their  own  experience.  But  when  the 
assumption  is  tested  by  the  facts  available  it  is  found  to  be  true. 
As  a  result  of  an  elaborate  study  of  91  cases  of  privileged 
subscription  the  tabulated  results  showed  that  in  somewhat 
over  half  the  cases  studied  the  stocks,  and  with  them  the  rights, 
sold  for  the  highest  price  at  the  beginning  of  the  subscription 
period.  In  one-half  of  the  remaining  cases — one-fourth  of 
all — the  stocks  and  rights  sold  for  most  at  the  middle  of  the 
period,  and  in  the  remaining  cases — again  one-fourth  of  all 
studied — they  sold  for  most  at  the  end  of  the  period. 

There  are  numerous  reasons  which  may  account  for  the 
fact  that  both  the  old  stock  and  the  rights  sell  for  most  at  the 
beginning  of  the  period.  In  the  first  place,  the  price  of  both 
is  determined  by  the  law  of  demand  and  supply.  Clearly,  a 
sudden  increase  in  the  supply  of  the  stock,  without  a  cor- 
responding sudden  increase  in  the  demand  for  it,  would  in- 
evitably depress  the  price  of  the  stock,  and  with  the  price  the 
market  quotations  for  the  rights.  But  this  will  not  react  on 
the  market  price  for  some  period  of  time,  or  until  the  influence 


286  CORPORATION  FINANCE  [  XXIII 

of  the  new  stock  begins  to  be  felt  in  the  increased  offerings,  so 
that  there  will  be  a  short  period  during  which  the  new  stock, 
although  its  existence  is  known,  will  not  be  a  factor  in  de- 
termining the  price  of  the  old.  But  as  the  new  stock  begins 
to  be  bought  and  sold  in  anticipation  of  its  issue,  it  will  begin 
to  exert  a  depressing  effect  on  the  price  of  the  stock  and  inci- 
dentally on  the  rights.  Another  direct  reason,  more  obvious  but 
less  potent,  that  explains  the  gradual  decline  in  market  price  of 
the  rights  and  with  them  the  stock  during  the  subscription 
period,  is  the  general  inertia  of  the  stockholders,  which  leads 
them  to  put  off  the  selling  of  their  rights  to  the  last  minute; 
meanwhile  the  "odd  lots"  of  rights  held  by  the  small  investors 
have  been  "evened  up,"  so  that  the  regular  sale  of  small  lots 
will  have  become  negligible.  Under  these  circumstances  the 
rights  that  are  offered  are  bought  only  by  speculators  who  see 
a  temporary  profit  in  this  purchase.  Naturally  such  a  class  of 
buyers  will  acquire  them  only  if  the  purchase  of  the  rights 
permits  the  subscription  to  the  new  stock  at  a  price  appreciably 
lower  than  its  general  market  price. 

Underwriting  Privileged  Subscriptions. — The  uncertaintv 
surrounding  the  privileged  subscription  and  the  effect  which 
it  is  likely  to  have  upon  the  market  price  of  the  stock  often 
make  it  unwise  for  a  corporation  to  trust  implicitly  in  the  suc- 
cess of  the  sale  of  stock  to  stockholders.  The  corporation 
requires  the  money  and  does  not  care  to  have  the  success  of  its 
sale  jeopardized  by  temporary  or  permanent  declines  in  the 
market  price  of  its  stock.  In  actual  operation  a  group  of  out- 
side bankers,  or  quite  commonly  the  more  wealthy  of  the 
directors,  insure  the  success  of  the  offering,  agreeing  to  take 
all  the  stock  not  subscribed  for  by  the  stockholders  themselves. 
For  this  service,  or  rather  for  taking  this  risk,  the  syndicate 
receives  a  commission  on  the  entire  amount  of  stock  offered, 
usually  about  2  per  cent.    In  case  the  stockholders  take  up  their 


XXIII]  NEW  CAPITAL  PROM  SALES  OF  STOCK  287 

entire  allotments  the  syndicate  is  required  to  take  no  stock, 
but  if  any  remains  unsubscribed  the  syndicate  takes  it  from  the 
corporation  at  the  price  which  the  stockholders  would  have 
paid.  The  risks  of  an  underwriting  syndicate  of  this  character 
are  considerable.  The  tastes  of  stockholders  are  fickle  and 
the  investment  market  uncertain.  But  a  group  of  bankers  is 
in  a  much  better  position  to  carry  these  risks  than  the  corpora- 
tion itself.  In  1903  the  Pennsylvania  Railroad,  then  in  the 
midst  of  enormous  expenditures  on  its  New  York  terminals — 
expenditures  which  many  regarded  as  of  doubtful  expediency 
— ofifered  its  stockholders  new  stock  for  $60  a  share,  the 
market  price  at  the  time  being  about  $72.  The  amount  to  be 
subscribed  was  $90,000,000,  an  amount  which  it  was  assumed 
would  be  absorbed  easily  by  the  old  stockholders.  But  the 
stock  was  not  to  be  subscribed  for  until  some  months  after 
the  announcement  of  the  subscription.  Meanwhile  financial 
conditions  became  unsettled,  stock  market  prices  of  all  securi- 
ties declined,  and,  in  particular,  doubt  was  cast  on  the  wisdom 
of  the  Pennsylvania  Railroad's  heavy  terminal  expenditures. 
As  a  result  of  all  these  circumstances  the  price  of  the  stock 
declined  to  a  little  less  than  $60  a  share.  If  it  had  remained 
below  $60  the  sale  to  the  stockholders  would  have  proved  a 
failure,  because  the  stock  could  be  more  cheaply  bought  in  the 
open  market.  Finally  a  syndicate  was  formed  which  for  a  com- 
mission of  2^  per  cent  guaranteed  to  the  railroad  the  success 
of  the  sale.  Immediately  after  the  formation  of  the  syndicate 
was  announced,  the  price  of  the  stock  advanced  and  ultimately 
most  of  the  new  stock  was  taken  by  the  stockholders.  The 
mere  fact  that  corporations  of  the  magnitude  and  strength 
of  the  Pennsylvania  Railroad  have  found  it  necessary  to  em- 
ploy underwriting  syndicates  of  independent  bankers  to  insure 
a  successful  sale  of  stock  to  their  stockholders  shows  how 
difficult  and,  on  the  whole  precarious,  is  this  method  of  obtain- 
ing money  for  expansion. 


CHAPTER  XXIV 

CORPORATE  FAILURE 

The  Importance  of  Reorganization. — The  failure  of  a 
corporation  is  distinctly  different  from  that  of  a  partnership. 
In  the  latter  case  the  business  would  ordinarily  have  no  bonded 
debt,  and  the  bank  and  merchandise  creditors  would  either 
force  the  business  to  liquidate,  or  else  compel  the  partners  to 
offer  some  plan  involving  the  partial  or  complete  payment  of 
the  debts.  The  case  of  the  small  corporation  is  similar.  In 
the  case  of  a  large  corporation,  on  the  other  hand,  there  are 
many  different  persons  interested  in  the  business.  It  is  a  com- 
plex organization.  No  one  is  personally  liable  for  the  debts 
in  case,  on  liquidation,  the  business  does  not  sell  for  the  amount 
of  its  liabilities.  Furthermore,  the  large  business  has  usually 
valuable  intangible  assets,  such  as  good-will,  which  retain  a 
value  only  if  the  business  is  continued.  So  that  even  when  it 
appears  that  the  business  may  be  disintegrated  and  the  parts 
sold  for  an  amount  sufficient  to  meet  the  creditors'  claims, 
the  stockholders  themselves  will  probably  deem  it  expedient 
to  invest  sufficient  new  money  to  pay  these  claims  immediately 
and  thus  save  the  business  and  its  organization  from  complete 
disruption.  In  this  way  a  new  or  reorganized  business,  free 
from  immediate  embarrassment,  starts  with  the  same  stock- 
holders as  the  old. 

If  the  corporation  furnishes  a  public  service  it  cannot  be 
closed  up,  even  if  the  various  parties  concerned  are  willing.  The 
courts  take  the  attitude  that  a  railroad,  or  an  electric  light  or 
gas  plant,  supplies  a  public  necessity  and  that  the  rights  of  the 
public  come  before  the  wishes  of  the  stockholders  or  even  the 
debts  of  the  creditors.    Except  in  extreme  cases  when  there  is 

288 


XXIV  ]  CORPORATE  FAILURE  289 

abundant  evidence  to  show  that  there  exists  no  pubhc  need, 
the  courts  will  insist  that  the  embarrassed  corporation  shall 
operate  its  trains  or  its  lighting  plant  through  the  agency  of  a 
receiver,  and  that  its  stockholders  and  creditors  shall  ultimately 
adjust  their  difficulties  and  reorganize  the  corporation  so  that 
it  may  continue  its  business  as  a  solvent  and  progressive  enter- 
prise. The  court  may  even  issue  securities  in  the  name  of  its 
receiver  which  take  precedence  over  the  claims  of  every  creditor 
of  the  corporation ;  it  may  decide  which  creditors'  claims  shall 
be  paid  and  which  shall  not;  and  it  may  otherwise  conduct 
the  business  in  an  arbitrary  manner,  provided  such  usurpation 
of  power  is  necessary  to  safeguard  the  interests  of  the  public. 
From  all  these  causes  the  probability  is  very  slight  that  an 
unprofitable  or  bankrupt  business,  meeting  an  obvious  need  of 
the  public,  will  be  disintegrated  and  the  parts  sold;  it  will 
be  voluntarily  or  forcibly  reorganized. 

Distinction  Between  Fundamental  and  Superficial  Causes. 
— In  discussing  the  causes  of  corporate  failure  it  is  convenient 
to  distinguish  between  three  phases  of  the  general  subject — 
the  fundamental  causes  of  failure,  the  superficial  causes  or 
conditions,  and  the  outward  signs.  These  three  are  usually 
confused,  even  by  economists.  We  may  go  even  further 
and  say  that  ordinarily  neither  the  men  who  are  responsible 
for  the  business  failure  nor  the  financial  experts  who  con- 
stitute themselves  an  investigating  committee,  ever  note  the 
difference  between  the  fundamental  and  abiding  causes  of 
financial  distress  and  the  mere  external  symptoms  that  stand 
out  clearly  in  the  foreground.  Business  men  are  usually  un- 
reflective.  In  a  very  true  sense  that  makes  them  aggressive 
and  quick  of  response,  because  action  is  not  imperiled  by  ir- 
resolution. It  does  not,  however,  make  them  successful  in 
diagnosing  their  own  troubles  or  those  of  their  associates. 
They  cannot  see  the  causes  of  business  failure  in  their  true 


290  CORPORATION  FINANCE  I XXIV 

perspective.  After  the  most  exhaustive  and  illuminating 
analysis  of  economic  causes  of  business  failure,  there  must 
stand  out  always  the  fact  that  a  business  fails  because  the 
managers  do  not  possess  the  necessary  intuitive  skill,  foresight, 
initiative,  perseverance,  and  intellectual  power  to  compel  its 
success.  Any  discussion  of  economic  advantages  or  disadvan- 
tages must  be  subordinate  to  the  conscious  recognition  of 
personal  characteristics.  Yet  recognizing  fully  these  psycho- 
logical conditions  leading  to  failure,  one  may  still  speak  of 
fundamental  economic  causes,  in  the  sense  of  economic  con- 
ditions which  will,  under  the  leadership  of  any  but  a  business 
genius,  lead  to  failure.  In  this  category  may  be  included  four 
— excessive  competition,  unprofitable  expansion,  a  change  in 
the  public  demand  for  the  commodity,  and  the  distribution  of 
capital  as  ostensive  profit. 

Fundamental  Economic  Causes — i.  Competition. — Com- 
petition is  a  necessary  and  wholesome  element  in  all  business 
enterprise.  Within  broad  limits,  the  keener  the  competition  the 
greater  will  be  the  business  efficiency  and  the  higher  the  range 
of  executive  ability  required  for  success.  It  becomes  a  true 
cause  of  failure  only  when  it  becomes  so  keen  that  the  most 
efficient  competitors  are  required  to  sell  at  less  than  cost.  In 
the  case  of  a  business  requiring  small  capital,  a  business  which 
can  be  created  or  liquidated  in  a  short  time,  the  most  efficient 
will  never  be  compelled  to  sell  for  less  than  cost.  Instead,  the 
less  able  managers  of  the  less  efficient  plants  will  wisely  stop 
producing  or  even  retire  from  business.  But  if  large  amounts 
of  capital  are  invested,  or  if  the  service  is  required  by  the 
public,  or  if  the  business  carries  itself  forward  by  the  sheer 
momentum  of  its  past,  it  can  neither  stop  producing  nor  go 
into  liquidation.  A  railroad  is  a  case  in  point.  It  cannot  cease 
to  exist.  If  the  rates  it  collects  for  its  services  are  insufficient 
to  pay  for  its  operation,  it  must  still  run  its  trains.     A  local 


XXIV]  CORPORATE  FAILURE  29 1 

public  service  company  is  ordinarily  protected  by  the  utility 
commission  of  the  state  in  the  exercise  of  monopoly  powers, 
provided  it  renders  good  and  reasonably  cheap  service  to  its 
customers.  Competition  is  a  relatively  unimportant  factor 
for  such  businesses,  unless  one  considers  the  competitive  in- 
fluence of  two  utilities — gas  and  electricity,  omnibuses  and 
street-cars.  In  manufacturing  businesses  the  plea  of  severity 
of  competition  can  be  advanced  but  seldom  as  a  fundamental 
cause  of  failure.  A  manufacturing  business  can  curtail  pro- 
duction even  at  the  expense  of  its  organization  rather  than 
dispose  of  its  product  at  less  than  cost.  It  is  true  competi- 
tion is  alleged  to  be  the  true  cause  of  many  failures,  but  the 
allegation  is  merely  an  excuse  to  obscure  the  deeper  defect  in 
business  management.  Too  keen  competition  is  invariably  the 
excuse  of  the  weak. 

2.  Unprofitable  Expansion — Unprofitable  expansion  is  a 
much  more  serious  and  a  much  more  common  cause  of  failure 
than  drastic  competition.  It  is  the  besetting  sin  of  a  fairly 
successful  corporation  with  a  relatively  large  margin  of  gross 
profit  based  on  a  small  output.  It  is  also  the  usual  cause  of  dis- 
aster among  corporations  favored  with  an  unusual  capacity  for 
borrowing  money.  While  overmastering  competition  occurs 
only  when  there  is  a  large  capital  investment,  the  temptation  to 
overexpand  is  present  in  every  business.  It  is  commonest  in  a 
country  like  the  United  States  where  the  margin  of  profit 
shows  marked  fluctuations  and  where  the  temperamental  bias 
of  optimism  is  magnified  by  an  inclination  to  regard  hopes 
for  the  future  as  things  predestined.  As  a  keen  judge  of 
business  conditions  remarked  to  some  students,  "When  vou 
have  a  business  that  is  growing  very  rapidly,  you  are  apt  to  be 
a  little  blinded  by  the  rapidity  of  it,  and  look  at  your  gross 
sales  rather  than  your  net  profits." 

The  number  of  instances  in  which  the  cause  of   failure 


292  CORPORATION  FINANCE  [XXIV 

is  overexpansion  are  legion,  but  for  the  present  purpose  it 
suffices  to  note  three,  drawn  from  the  manufacturing,  the 
pubHc  service,  and  the  railroad  industries. 

Overexpansion  of  a  Manufacturing  Industry.  One  of  the 
striking  instances  of  failure  due  to  overexpansion  of  an  other- 
wise successful  manufacturing  business  is  afforded  by  the 
history  of  the  Westinghouse  Electric  and  Manufacturing  Com- 
pany. Starting  in  1886  with  sales  amounting  to  less  than 
$150,000,  the  business  grew  by  leaps  and  bounds.  During  the 
year  1894,  a  period  showing  relatively  little  business  activity, 
the  Westinghouse  Company,  on  a  capital  including  bonds  and 
current  debts  of  less  than  $10,000,000,  showed  a  net  profit  of 
over  16  per  cent.  Expansion  continued.  The  company  or- 
ganized foreign  departments  and  finally  foreign  factories.  It 
financed  interurban  electric  railway  lines  for  the  purpose  of 
exploiting  its  inventions;  it  advanced  large  sums  to  unproduc- 
tive subsidiary  companies.  By  1906  its  total  funded  and  cur- 
rent liabilities  and  stock  had  risen  to  $45,000,000  but  the  net 
profit  was  only  a  little  over  $3,000,000,  or  only  5  per  cent.  No 
theoretical  economist  ever  discovered  a  clearer  illustration  of 
the  law  of  diminishing  returns.  As  a  small  business  in  a  year 
of  depression,  the  Westinghouse  Company  earned  16  centL 
on  every  dollar  of  invested  capital ;  as  a  large  business  in 
a  year  of  marked  prosperity,  it  earned  5  cents  on  each  dollar. 
It  failed  the  year  following. 

Overexpansion  of  a  Public  Service  Holding  Company. 
The  second  type  of  illustration  comes  from  the  field  of  the 
holding  company,  or  more  particularly  the  public  service  hold- 
ing company.  As  explained  in  another  connection,  this  type 
of  enterprise  became  very  popular  in  the  years  following  the 
panic  of  1907,  when  capital  was  seeking  new  channels  of  invest- 
ment. The  first  two  or  three  of  these  companies  were  success- 
ful from  the  beginning,  notably  the  original  United  Gas 
Improvement   Company,  and   later  the  American   Light   and 


XXIV  ]  CORPORATE  FAILURE  293 

Traction  and  the  American  Gas  and  Electric  companies.  In 
finance,  as  in  all  other  fields  of  endeavor,  there  are  always 
hosts  of  imitators  whenever  a  new  development  seems  to  point 
the  way  to  an  easy  success.  Public  service  holding  companies 
sprang  up  all  over  the  country.  As  their  profits  consisted 
entirely  in  the  increment  of  earnings  remaining  to  generous 
issues  of  common  stock  of  the  local  operating  companies,  it 
seemed  to  the  operators  of  these  companies  that  the  greater 
the  number  of  utilities  controlled  the  greater  must  be  the 
profit.  The  success  of  the  American  Light  and  Traction 
Company  was  due  to  the  careful  selection  of  properties  to  be 
acquired,  conservative  management,  and  shrewd  finance.  Its 
imitators,  however,  lacked  these  three  elements  of  success — 
they  lacked  particularly  care  in  selecting  new  properties. 
Economy  was  sacrificed  to  mere  size.  This  foolhardy  mania 
for  expansion  reached  its  climax  toward  the  end  of  191 1  just 
before  the  decline  of  the  stock  market  values  which  ended  in 
the  close  of  the  Stock  Exchange,  July  30,  1914.  Subjected 
to  a  shrinking  market  for  credit,  these  recently  organized 
holding  companies  were  in  dire  straits.  Most  of  them  resorted 
to  the  issue  of  short-time  notes,  either  to  meet  the  demands 
of  their  subsidiaries,  or  to  fulfil  already  existing  contracts. 
Some  of  them  used  borrowed  money  to  maintain  the  interest  on 
their  bonds.  Several  went  into  the  hands  of  receivers.  Others 
passed  their  preferred  stock  dividends  or  gave  scrip  for  them. 
They  all  advanced  excuses — a  tight  money  market,  increased 
taxes  and  labor  costs  of  the  operating  companies,  and  latterly 
a  difficulty  in  selling  securities  because  of  the  Great  War.  But 
the  fundamental  reason  was  not  given.  The  companies  had 
spread  their  resources  and  their  credits  so  thin  that  the  cover 
had  begun  to  break. 

Over  expansion  of  Railroads.  In  the  field  of  railroad  enter- 
prise the  influence  of  unwise  expansion  was  much  more  potent 
than  that  of  keen  competition  even  during  the  decade  before 


294  CORPORATION  FINANCE  f  XXIV 

the  panic  of  1893,  although  excessive  competition  has  been 
advanced  as  the  primary  cause  of  the  numerous  receiverships 
of  that  time.  When  the  Northern  Pacific  passed  into  the  hands 
of  receivers  the  road  was  facing  an  annual  loss  of  over 
$1,500,000,  caused  very  largely  by  its  unprofitable  branch 
extensions.  The  Atchison  in  its  foolish  expansion  from  1884 
to  1888  illustrates  the  principle  clearly.  In  the  former  year 
with  2,800  miles  of  line  the  road  made  net  earnings  of  $2,600 
a  mile;  in  the  latter  year  with  7,000  miles  of  line  it  earned  only 
$700  a  mile.  In  the  former  year  the  road  had  over  $5,000,000 
available  for  its  stockholders ;  in  the  latter  year  there  was  a  net 
deficit  of  $3,000,000.  Looking  at  the  matter  another  way,  the 
Atchison  system  earned  6^  per  cent  on  its  total  outstanding 
bonds  and  stock  in  1884,  and  2^  per  cent  in  1888. 

Among  eastern  roads  the  failure  of  the  Reading  in  1880 
was  due  directly  to  the  purchase,  at  a  cost  of  $73,000,000, 
of  coal  lands  valued  at  the  time  at  $30,000,000,  and  the  re- 
ceivership of  1884  to  the  lease  of  the  Central  Railroad  of 
New  Jersey  which  guaranteed  a  dividend  of  6  per  cent  on  its 
stock  when  the  interest  on  its  bonds  was  not  earned.  The 
Reading's  failure  of  1893  can  be  traced  to  the  burdens  of  the 
Central  New  Jersey  and  Lehigh  Valley  leases,  together  with 
wild  speculations  in  the  stocks  of  New  England  railroads. 
So  that  each  of  the  three  failures  of  the  Reading  can  be  at- 
tributed, unhesitatingly  and  without  a  suspicion  of  doubt, 
to  unprofitable  expansions. 

The  most  conspicuous  railway  failure  of  the  last  few  years 
due  to  unprofitable  expansion  is  that  of  the  New  Haven 
system.  Brushing  aside  for  the  moment  all  the  secondary 
causes  that  led  to  one  of  the  most  unfortunate  and  unnecessary 
failures  of  railroads,  the  primary  fact  stands  out  that  the  New 
Haven  Railroad  itself  was  ruined  by  the  insane  craze  of  its 
bankers  and  directors  so  to  extend  its  sphere  of  control  as  to 
embrace  a  monopolistic  system  of  transportation  covering  all 


XXIV]  CORPORATE  FAILURE  295 

of  New  England.  Sustained  by  the  hope  of  ultimately  securing 
monopoly  profits  and  thereby  justifying  the  outlay,  stimulated 
by  the  surreptitious  profits  obtained  by  its  directors  and  by  the 
ease  with  which  it  received  credit  from  New  England  in- 
vestors, the  road  plunged  headlong  into  a  series  of  expenditures 
which  embraced  traction  companies,  steamship  lines,  connecting 
railroads,  even  gas,  light,  and  water  companies,  until  the 
legitimate  profits  from  the  railroad  were  more  than  offset  by  the 
losses  on  the  outside  enterprises.  Thus  in  1899,  on  a  total 
capitalization  of  $80,000,000,  including  bonds  and  stocks,  the 
company  earned,  above  operating  expenses  and  taxes,  almost 
exactly  $10,000,000,  or  approximately  12  per  cent  on  the 
capitalization.  This  was  before  any  outside  operations  were 
undertaken.  In  1914,  after  the  completion  of  the  policy  of 
expansion,  the  total  outstanding  capitalization  had  increased 
to  $417,000,000,  while  the  railroad  mileage  stood  at  exactly 
the  same  figure.  The  net  income  available  for  interest  and 
dividends  on  capital  had  increased  to  $21,500,000,  but  that 
was  only  5  per  cent  on  the  outstanding  stock  and  debt — less 
than  half  what  it  was  before  the  period  of  outside  speculations. 
In  brief,  during  the  fifteen  years  between  1899  and  1914  the 
railroad  mileage  of  the  New  Haven  system  was  not  increased. 
Yet  during  the  period  invested  capital  became  five  times  as  great 
and  the  earnings  only  twice  as  great. 

All  these  failures  due  to  unwarranted  extensions  illustrate 
the  economic  law  of  diminishing  returns.  This  is  more  than 
a  mere  academic  doctrine  of  scholastic  economists.  It  is  a 
vital  force  operating  in  actual  business.  If  a  certain  investment, 
say  of  $1,000,000  in  a  manufacturing  plant  or  a  railroad, 
yields  a  net  profit  of  10  per  cent,  it  does  not  follow  that  an 
investment  twice  as  great  will  yield  twice  as  great  a  profit.  On 
the  contrary,  wastes  incident  to  the  bigger  business  will  creep 
in,  so  that  the  profit,  although  perhaps  greater  in  actual  amount, 
will  be  smaller  proportionately.    And  if  the  investment  be  con- 


296  CORPORATION  FINANCE  [XXIV 

tinued  without  limit  the  dedine  in  actual  earnings  with  the 
later  investments  will  even  obliterate  the  profit  on  the  earlier 
investments.  In  brief,  after  a  certain  point,  as  capital  is  added 
to  any  industry,  the  rate  of  return  on  each  dollar  invested  grows 
smaller.  It  is  true  that  up  to  a  certain  point,  the  point  of 
saturation,  as  it  were,  the  profit  tends  to  increase.  But  this 
point  is  early  reached.  The  optimism  of  business  men,  the 
avarice  of  bankers,  and  the  enthusiasm  of  engineers  easily 
carry  the  business  beyond  it. 

3.  Cessation  of  Public  Demand. — A  third  deep-lying  eco- 
nomic cause  of  failure  is  the  change  in  the  conditions  of  public 
demand.  Such  a  case,  however,  is  relatively  rare.  The  failure 
of  the  old  American  Bicycle  Company  is  a  case  in  point.  This 
combination  acquired  in  1898  some  48  bicycle  plants  producing 
upwards  of  65  per  cent  of  the  bicycles  made  in  the  United 
States.  According  to  reliable  auditors  the  annual  profits  of 
these  plants  had  together  averaged  nearly  $5,000,000  for  the 
preceding  four  years.  Appraisal  by  reliable  independent  ex- 
perts showed  actual  property  to  the  value  of  over  $22,000,000, 
of  which  upwards  of  $12,000,000  consisted  of  net  quick  assets. 
All  this  augured  well  for  the  combination.  The  total  number 
of  bicycles  sold  fell  from  860,000  in  1899  to  100,000  in  1902. 
Suddenly,  with  no  warning,  the  public  ceased  to  use  its  toy. 
As  a  result  the  millions  of  dollars  of  property  set  aside  for  the 
manufacture  of  bicycles  became  useless  and  the  company  failed. 
Even  after  $2,500,000  in  new  money  was  added  to  adapt  the 
factories  for  the  manufacture  of  automobiles,  it  was  no  more 
successful.     The  reorganized  company  failed  twice  thereafter. 

4,  Excess  Payment  of  Capital  Charges. — The  fourth  of  the 
group  of  fundamental  economic  causes  of  failure  is  entirely 
financial.  It  is  the  payment  of  excessive  interests  or  dividends 
due  to  a  mistaken  belief  in  the  profitableness  of  the  enterprise. 


XXIV  ]  CORPORATE  FAILURE  297 

Such  payments  may  often  be  excused  on  the  ground  of  uncon- 
servative  but  technically  correct  principles  of  accountancy — 
principles  which,  for  example,  may  be  theoretically  defensible 
but  are  unquestionably  unjustifiable  in  practice.  The  corpora- 
tion which  employs  them  becomes  insolvent  whatever  the  text- 
books of  accountancy  may  say.  At  other  times  the  payment  of 
interest  or  dividends  in  excess  of  profits  cannot  be  justified  by 
any  theory  and  can  be  called  nothing  short  of  fraud.  Thus  the 
American  Malting  Company,  in  a  notable  case  that  came  before 
the  courts,  paid  out  nearly  $900,000  in  dividends,  while  its 
gross  profit,  without  allowing  for  depreciation  or  special  re- 
serves, amounted  to  $500,000.  In  1872  the  old  Erie  Railway 
was  rescued  by  Daniel  E.  Sickles  from  the  notorious  Drew- 
Fisk  clique.  In  the  three  following  years  the  road  earned  a 
profit  of  $1,008,775,  but  its  directors  represented  the  profit  to 
be  $5,352,573,  on  the  basis  of  which  dividends  were  paid 
on  the  preferred  and  common  stocks.  Meanwhile,  $6,000,000 
of  bonds  were  sold.  From  1888  to  1895,  or  in  seven  years 
before  its  failure,  the  Baltimore  and  Ohio  paid  out  $6,269,008 
in  dividends,  whereas  an  independent  auditor  found  that  less 
than  $1,000,000  had  been  actually  earned.  In  1887  the  direc- 
tors of  the  Atchison  road  increased  the  dividend  rate  from 
6  to  7  per  cent  at  a  time  when  the  net  earnings  of  the  road 
were  actually  falling  short,  by  over  $2,000,000,  of  the  interest 
and  rental  requirements.  And  this  situation  is  present  in 
the  contemporary  railroad  troubles.  Although  the  failure  of 
the  St.  Louis  and  San  Francisco  Railroad  in  191 3  was  due  pri- 
marily to  unprofitable  extensions,  it  was  aggravated  in  no 
small  measure  by  the  payment  of  excessive  charges  on  the 
securities  of  the  Chicago  and  Eastern  Illinois.  The  weak- 
ness of  the  Toledo,  St.  Louis  and  Western  Railroad,  which 
passed  into  the  hands  of  receivers  in  October,  19 14,  was  due 
to  the  excessive  capital  charges  resulting  from  the  burdensome 
charges  of  the  Chicago  and  Alton  Railroad. 


298  CORPORATION  FINANCE  [XXIV 

It  is  important  to  observe  also  that  although  the  occasion 
for  the  payment  of  unearned  dividends  and  interest  may  be 
traced  back  to  overexpansion,  and  for  that  reason  overex- 
pansion  is  to  be  regarded  as  the  fundamental  cause  of  distress, 
still  the  payment  of  unearned  capital  charges  has  in  many  cases 
directly  precipitated  failure. 

This  is  particularly  true  of  railroad  systems  constructed 
out  of  numerous  component  parts,  and  of  industrial  combina- 
tions promoted  in  the  expectation  of  receiving  monopoly 
profits.  Thus,  of  24  cases  of  industrial  failure  examined  in 
another  connection,  it  was  found  that  "18  out  of  the  24  paid 
either  unearned  interest  on  bonds  or  unearned  dividends  on 
stock  in  the  year  just  prior  to  the  failure  or  reorganization," 
and  that  "every  corporation  paid  out  interest  or  dividends  in 
the  face  of  falling  earnings  and  none  need  have  suffered 
serious  financial  difficulties  had  the  amounts  paid  in  interest 
and  dividends  been  conserved." 

While  it  is  entirely  possible  and  safe  to  draw  on  a  large 
surplus  in  order  to  maintain  interest  or  dividend  payments 
for  a  single  year  or  even  two  years  of  reduced  business,  the 
policy  is  at  best  questionable.  No  doubt  the  New  Haven 
Railroad's  plight  was  aggravated  by  the  fact  that  in  the  four 
years  from  1910  to  1915  the  dividend  payments  every  year 
exceeded  the  profits  available.  No  suf^cient  excuse  for  the 
mistake  can  be  found  in  the  desire  to  protect  the  small  investor 
or  in  the  hope  of  maintaining  the  company's  credit  among  sav- 
ings banks.  This  entire  matter  has  been  discussed  in  its  proper 
place  before,  but  it  is  important  to  note  again  that  the  continued 
payment  of  interest  or  dividends  in  excess  of  earnings  can  have 
only  one  outcome,  however  successful  the  policy  may  appear 
to  be  for  a  short  period. 


CHAPTER  XXV 

REORGANIZATION  METHODS 

Contraction  of  Financial  Plan. — When  a  corporation  fails 
or  becomes  embarrassed  its  financial  plan  is  usually  remolded. 
This  is  reorganization.  It  is  a  redrawing  of  the  financial  plan, 
but  with  a  view  to  contraction,  not  to  expansion.  Whether  the 
new  plan  provides  for  contraction  or  expansion,  new  money  is 
required,  but  an  expanding  and  profitable  business  may  ordin- 
arily solicit  new  capital  on  the  basis  of  its  past  success,  whereas 
a  bankrupt  business  secures  capital  only  through  coercion. 
Unwillingly  its  security-holders  add  more  money  merely  to  save 
that  already  invested.  So  easy  is  it  to  obtain  money  for  the 
expansion  of  a  successful  business  by  one  of  several  ways 
that  the  question  is  merely  one  of  financial  expediency;  so 
difficult  is  it,  on  the  other  hand,  to  obtain  the  money  neces- 
sary to  reorganize  an  unsuccessful  corporation  that  the  success 
of  the  reorganization  depends  primarily  on  selecting  that  plan 
which  shall  achieve  this  one  end  with  the  least  friction. 

Factors  Involved. — Owing  to  the  delicacy  of  the  situation 
and  the  judgment  required,  corporate  reorganization  is  the 
most  intricate  phase  of  the  whole  field  of  finance  and  the  one  in 
which  generalizations  and  precedents  are  least  significant.  It 
is  a  subject  which  has  as  its  elements  a  mass  of  conflicting 
legal  precedents,  the  makeshifts  of  mere  temporary  expedients, 
and,  permeating  the  whole,  the  psychological  bias  and  preju- 
dices of  thousands  of  dissatisfied  human  beings  whose  interests 
are  in  fundamental  conflict.  The  primary  purpose  of  every 
reorganization  is  justice  to  all  concerned.  But  the  justice  is 
tempered — one  might   almost   say  obscured — by   motives   of 

299 


300  CORPORATION  FINANCE  [XXV 

expediency.  Compulsion  is  exerted  at  one  or  more  points. 
This  requires  the  arm  of  the  law.  Moreover,  even  when  the 
statutory  law  presents  no  difficulties,  there  are  always  conflict- 
ing precedents  and  legal  opinions.  In  addition  to  the  legal  aids 
and  impediments  there  are  important  financial  questions  of 
mere  judgment — the  ease  with  which  an  underwriting  may  be 
obtained,  to  what  extent  the  stockholders  may  be  counted  on 
to  add  money,  what  may  be  the  opportunity  for  selling  bonds 
during  the  first  year  of  the  new  company's  life.  In  answer- 
ing these  questions  in  any  one  particular  case  precedents  are  of 
little  value.  Each  reorganization  is  different  from  all  that  have 
occurred  before  in  one  or  more  important  respects. 

Importance  of  Study  of  Reorganization. — Yet  in  spite  of  its 
intricacy,  a  study  of  the  reorganization  of  corporations  is  one 
of  the  most  important  in  the  field  of  finance.  In  the  past,  hun- 
dreds of  millions  of  dollars  of  actual  property  investment  have 
been  involved  in  reorganizations.  Great  railroad  systems  like 
those  of  the  Atchison  and  the  Reading,  great  traction  systems 
like  those  of  the  New  York  City  and  the  Chicago  surface 
lines,  great  manufacturing  industries  like  that  of  the  Westing- 
house  Company,  involving  thousands  of  laborers  and  the 
production  of  necessities  of  modern  civilization,  have  all  been 
subjected  to  the  uncertainties  of  reorganization.  These  enter- 
prises have  involved  much  more  than  the  mere  fortunes  of  the 
wealthy ;  they  have  been  concerned  with  the  savings  of  a  great 
multitude  of  people,  including  the  very  poor.  Frequently  the 
savings  of  a  man's  lifetime  have  been  jeopardized  by  a  single 
man's  interpretation  of  justice  in  a  reorganization  plan.  Prob- 
ably the  ablest  men  in  law,  finance,  and  productive  industry 
have  given  some  of  their  best  efforts  to  the  solution  of  the 
intricate  problems  involved.  The  regrettable  feature  is  that 
in  spite  of  all  precedents  each  new  reorganization  is  quite 
as   perplexing   as   those   that   have   gone    before.      Only   the 


XXV]  REORGANIZATION  METHODS  301 

most  vague  and  inexact  theories  and  generalizations  can  be 
made. 

Reorganization  of  a  Large  Corporation, — A  large  business 
is  not  ordinarily  closed,  its  property  sold,  and  the  proceeds 
divided  up  among  the  creditors.  It  is  reorganized.  Sometimes 
this  is  done  publicly,  with  all  th'e  dislocation  and  notoriety  that 
usually  attends  business  misfortune;  sometimes  it  is  done  quietly 
through  conferences  and  concerted  action  by  all  the  persons 
concerned.  The  former  is  a  reorganization  through  a  court 
receivership  and  the  latter  a  reorganization  through  a  friendly 
committee.  The  former  method  was  and  still  is  pursued  in 
case  of  the  failure  or  expected  failure  of  a  large  corporation 
with  many  security-holders  and  creditors  of  diverse  interests. 
Under  these  circumstances  close  co-operation  is  impossible  and 
the  whole  readjustment  must  occur  under  the  supervision  of  the 
court. 

The  procedure  followed  at  the  present  time  in  effecting  the 
reorganization  of  a  large  business  corporation  has  developed 
through  a  series  of  precedents,  each  one  of  which  was  estab- 
lished originally  more  through  accident  than  forethought. 
Ordinarily  a  fundamentally  important  mode  of  procedure,  in 
financial  as  well  as  other  social  affairs,  results  from  a  slow  and 
tempered  growth  of  precedents,  all  of  which  are  firmly  rooted 
in  the  common  or  the  statutory  law,  and  all  of  which  are  con- 
stantly balanced  off  against  contemporary  social  opinion.  The 
history  of  the  organization  of  the  business  corporation,  the 
history  of  the  public  franchise,  the  history  of  the  practice  of 
corporate  taxation,  are  all  illustrations  of  the  orderly  and  well- 
regulated  development  of  a  body  of  well-considered  precedents, 
consistent  at  all  times  with  the  law  and  with  public  opinion. 
Not  so  the  present  practices  governing  the  reorganization  of 
financially  embarrassed  corporations.  They  have  arisen  through 
immediate  necessities;  they  have  come  into  existence  at  times 


302  CORPORATION  FINANCE  [XXV 

when  any  action,  legal  or  illegal,  impetuous  or  reflective,  was 
better  than  no  action. 

Motives  Governing  Procedure. — Three  separate  and  often 
antagonistic  sets  of  motives  govern  the  procedure  to  be  fol- 
lowed in  the  reorganization  of  any  kind  of  large  corporation. 
The  most  important  and  usually  the  least  apparent  is  concerned 
with  the  human  or  psychological  elements.  Most  writers  on 
finance,  taking  their  promptings  from  published  circulars  and 
reports,  forget  the  interplay  of  human  motives,  ambitions,  an- 
tagonisms, and  friendships  that  underlie  every  financial  episode 
of  importance.  A  corporation  is  reorganized  by  men,  not 
puppets;  its  officers,  its  creditors,  its  security-holders,  the  at- 
torneys, and  the  judges,  are  not  mere  thinking  machines,  but 
ordinary  men  subject  to  human  emotions  and  weaknesses. 
First  then,  the  procedure  must  be  such  as  to  allay,  not  aggra- 
vate, the  friction  incident  to  the  conflict  of  personalities.  The 
second  set  of  motives  governing  reorganization  procedure  is 
economic.  Leases  must  be  continued  or  abrogated,  contracts 
rewritten,  rights  enforced  or  surrendered,  in  accordance  with 
the  single  question — Is  it  profitable?  No  corporation  can 
be  permanently  successful  and  serve  the  public  well  which 
does  not  pay  its  operating  expenses,  including  fair  wages  to 
its  employees,  with  adequate  upkeep  of  its  plant,  and  in  addition 
a  fair  rate  of  return  on  the  invested  capital.  And  the  reorgani- 
zation procedure  must  recognize  this  simple  economic  impera- 
tive. The  third  set  of  controlling  motives  is  legal  and  judicial. 
Experienced  students  of  legal  practice  have  worked  out  certain 
more  or  less  clearly  defined  lines  of  orderly  procedure.  Some 
of  these  lines  of  procedure  have  been  prescribed  by  the  courts, 
others  are  merely  tolerated  by  the  courts  because  they  facilitate 
the  regular  course  of  the  reorganization,  and  others,  arising 
from  the  ingenuity  of  lawyers,  are  followed  until  some  court 
decision  condemns  them.    Lawyers  are  apt  to  exaggerate  their 


XXV 1  REORGANIZATION  METHODS  303 

own  importance  and  the  significance  of  their  legal  machinery 
in  determining  the  form  and  details  of  reorganization  pro- 
cedure, forgetful  that  a  reorganization  is  primarily  an  ad- 
justment of  human  motives  and  economic  conditions,  circum- 
scribed rather  than  determined  by  the  law.  The  present  orderly, 
and  on  the  whole  socially  expedient,  procedure  in  connection 
with  the  reorganization  of  all  corporations  large  and  small,  has 
been  built  up  from  the  interplay  of  these  three  underlying 
motives. 

Events  Immediately  Preceding  Failure. — The  explicit  fail- 
ure of  an  industrial  company  may  come  suddenly,  as  the  im- 
mediate consequence  of  a  labor  strike,  a  panic,  or  a  bank  failure, 
or  even  the  death  of  an  important  director.  A  railroad  failure, 
or  the  failure  of  a  local  utility,  invariably  due  to  deep-seated, 
slow-acting  causes,  may  often  be  postponed  or  quickened  at  the 
discretion  of  those  in  immediate  control.  At  all  events,  when 
the  financial  and  operating  conditions  of  the  corporation  reach 
such  a  pass  that  a  crisis  seems  inevitable  to  the  management,  it 
takes  one  or  both  of  the  two  steps — the  organization  of  pro- 
tective committees,  and  the  petition  for  the  appointment  of  a 
receiver.  Sometimes  committees  close  to  the  management 
are  formed  before  failure  has  reached  a  critical  stage,  one 
of  the  avowed  purposes  being  to  prevent  or  forestall  receiver- 
ship proceedings ;  and  sometimes  receivership  proceedings  are 
brought  suddenly,  and  almost  at  the  last  moment,  before  the 
management  has  an  opportunity  to  organize  a  "stockholders' 
committee."  Thus  no  general  rule  can  be  laid  down  covering 
the  order  of  these  two  events,  but  the  public  acknowledgment  of 
financial  failure  is  indicated  if  one  or  the  other  or  both  of  them 
occur. 

Formation  of  Committees.. — The  organization  of  protective 
committees  is  more  important  than  the  receivership  proceed- 


304  CORPORATION  FINANCE  f  XX^ 

ings,  the  latter  being  a  legal  formality  now  dispensed  with 
when  the  corporation  is  small,  the  parties  concerned  few,  and 
the  fundamental  difficulty  easily  ascertained  and  remedied. 
The  committees  arise  from  two  different  sources.  There  is, 
first,  the  stockholders'  committee,  usually  dominated  by  the 
old  directors  of  the  corporation.  This  committee  acts  on  the 
defensive;  throughout  the  whole  course  of  the  reorganization 
proceedings  the  stockholders'  committee  is  engaged  in  explain- 
ing and  justifying  the  past  management  and  haggling  with  the 
other  committees  in  regard  to  the  extent  of  the  sacrifices 
which  the  old  stockholders  must  undergo  in  order  to  regain 
the  control  of  the  corporation.  The  other  types  of  committees 
are  representative  of  different  classes  of  creditors.  In  the 
reorganization  of  a  small  industrial  corporation  there  is,  in 
addition  to  the  stockholders'  committee,  only  one  committee 
of  creditors.  In  intricate  industrial  reorganizations  there  may 
be  separate  committees  representing  the  merchandise  creditors, 
the  bank  creditors,  and  the  public  holders  of  the  notes  and 
debentures.  In  intricate  railway  reorganizations  there  may 
be  committees  of  junior  bondholders,  of  senior  bondholders, 
of  branch  and  divisional  line  bondholders,  and  of  the 
bondholders  of  subsidiary  lines  or  terminal  properties  con- 
trolled through  leases  or  operating  contracts.  The  com- 
mittees of  the  holders  of  the  floating  debt  are  usually  formed 
and  dominated  by  the  large  bank  creditors.  The  committees 
of  bondholders  are  formed  and  dominated  by  the  investment 
banking  houses  which  were  responsible  for  the  original  sale 
of  the  bonds  to  the  public;  if  the  bonds  were  distributed  long 
ago,  prominent  trust  companies  or  life  insurance  companies 
may  assume  the  guiding  hand. 

The  committee  or  committees  representing  the  floating 
debt,  the  junior  bonds,  the  notes  and  debentures,  will  stand 
antagonistic  to  the  committee  of  stockholders.  The  committees 
of   senior   bondholders    will    assume   throughout   an    attitude 


XXV 1  REORGANIZATION  METHODS  3^5 

of  watchful  waiting.  In  the  majority  of  cases,  especially  if 
the  property  is  a  railroad  and  the  lines  covered  by  these  liens 
are  strategically  important  for  the  unity  of  the  railway  system, 
these  committees  will  be  called  upon  to  take  little  part  in  the 
reorganization.  If,  as  is  the  case  in  comprehensive  railroad 
reorganizations,  they  are  required  to  fund  their  bonds  under 
new  first  and  general  mortgages,  they  will  be  able  to  prescribe 
the  conditions  which  the  junior  bondholders  and  stockholders 
must  accept.  It  facilitates  matters  very  much  if  the  important 
committees  agree  among  themselves  upon  the  formation  of 
a  general  reorganization  committee  upon  which  representatives 
of  the  different  committees  serve. 

Classifications  According  to  Legal  Procedure. — The  char- 
acter and  the  significance  of  the  legal  aspects  of  a  reorgani- 
zation depend  very  largely  on  whether  or  not  a  receiver  is 
appointed  to  administer  the  business  during  the  period  between 
the  financial  crisis  and  the  final  consummation  of  the  reorgani- 
zation. This  in  its  turn  depends  on  whether  or  not  there  is 
likely  to  be  acrimonious  and  prolonged  dispute  among  the 
various  security-holders,  and  whether  or  not  a  recalcitrant 
group  of  security-holders  is  likely  to  try  to  impede  or  even 
frustrate  an  amicable  settlement  of  conflicting  interests.  If 
the  failure  is  very  serious,  thus  entailing  large  losses  to  all 
concerned,  or  if  it  involves  a  large  railway  embodying  many 
conflicting  interests,  or  if  there  are  burdensome  leases  and 
contracts  which  must  be  abrogated  at  all  hazards,  then  re- 
ceivership proceedings  are  necessary. 

A  drastic  but  fair  reorganization  can  be  carried  through 
in  an  autocratic  manner  if  a  receivership  is  resorted  to,  be- 
cause in  the  end,  by  a  judicial  sale  of  the  bankrupt  corpora- 
tion's property,  the  court  can  force  a  recalcitrant  minority 
to  accept  what  it  considers  a  just  reorganization  plan  or  ex- 
tinguish the  interests  of  the  minority.     But  if  the  reorgani- 


306  CORPORATION  FINANCE  (  XXV 

zation  is  that  of  a  small  industrial  corporation,  the  opposing 
parties  of  which  are  two  or  more  closely  knit  factions  who 
are  able  to  compose  their  differences,  or  if  the  crisis  is  merely 
temporary  so  that  little  permanent  sacrifice  is  required  of  any- 
body, then  the  various  security-holders  can  probably  arrange 
a  plan  of  reorganization  among  themselves  without  resort  to 
the  machinery  of  the  courts.  A  reorganization  consummated 
without  compulsory  pressure  exerted  by  the  courts  through 
judicial  sale,  even  though  a  receiver  be  appointed  at  some 
stage  in  the  proceedings,  is  called  "voluntary,"  one  consum- 
mated through  the  coercive  authority  of  the  courts,  represented 
by  a  judicial  sale  of  the  property  of  the  old  corporation  and  the 
reorganization  of  a  new  corporation,  is  called  "involuntary." 
The  vast  majority  of  railroad  organizations  are  involuntary 
and  follow  a  court  receivership,  although  from  time  to  time 
voluntary  reorganizations  have  been  attempted  for  large  rail- 
way systems,  and  sometimes  they  have  been  successfully  con- 
summated. There  have  been  many  voluntary  reorganizations 
of  large  and  small  industrial  and  local  public  utility 
corporations. 

The  paramount  advantage  of  a  voluntary  reorganization 
is  that  it  preserves  valuable  rights.  The  whole  reorganization 
can  be  carried  out  with  little  outward  formality  and  without 
harming  the  general  credit  of  the  corporation  or  any  good- 
will values  belonging  to  its  trade-marks  or  franchises.  The 
objections  to  such  a  reorganization  lie  entirely  in  the  difficulty 
of  its  execution  and  in  the  large  amount  of  securities  which 
must  be  issued  in  order  to  please  everybody  concerned.  In 
several  large  and  important  reorganizations  of  this  kind  it 
has  been  found  expedient  to  carry  on  parts  of  the  reorgani- 
zation under  the  protection  of  the  court.  The  number  of  these 
voluntary  reorganizations,  aside  from  minor  capital  readjust- 
ments, has  been  relatively  small.  And  in  all  respects,  except 
in  certain  details  of  legal  procedure,   voluntary   reorganiza- 


XXV 1  REORGANIZATION  METHODS  30? 

tions  are  similar  to  those  consummated  through   foreclosure 
sale. 

Appointment  of  a  Receiver. — In  the  vast  majority  of  cases, 
the  first  step  in  the  legal  procedure  of  the  reorganization  is 
the  appointment  of  a  receiver  by  a  court  of  equity.  Brushing 
aside  exceptional  conditions,  the  usual  practice  in  the  consent 
receiverships  may  be  very  briefly  stated.  The  necessity  or 
desirability  of  a  receivership  having  been  agreed  upon  by  the 
directors  (usually  in  a  secret  meeting),  some  friendly  general 
creditor  with  a  claim  in  excess  of  $3,000,  not  residing  in  the 
same  state  as  that  in  which  the  corporation  has  its  main  office, 
is  asked  to  allow  his  name  to  be  used  in  the  receivership  pro- 
ceedings. Accordingly  the  attorneys  for  the  corporation  pre- 
pare the  necessary  bill  of  complaint  to  which  the  creditor  com- 
placently signs  his  name.  The  attorneys  at  the  same  time 
prepare  the  corporation's  answer,  which  admits  the  allegations 
of  the  creditor's  bill  and  prays  for  the  appointment  of  a  re- 
ceiver. The  court  grants  the  prayer  and  appoints  one  or  more 
receivers.  Subsequently,  the  trustee  of  the  general  junior 
mortgage  brings  a  foreclosure  bill  in  the  court  of  primary 
jurisdiction  and  the  same  receivers  are  appointed  as  under 
the  creditor's  bill.  At  least  one  receiver  is  one  of  the  old 
officials  of  the  corporation,  familiar  with  routine  administra- 
tion, whose  name  is  suggested  to  the  court  at  the  time.  The 
other  receiver  is  a  lawyer  or  publicist  in  whom  the  court  has 
explicit  confidence. 

As  soon  as  the  receiver  of  a  corporation  has  been  appointed 
he  assumes  the  management  of  the  business.  Ordinarily, 
especially  with  large  corporations,  such  as  railroads  and  trac- 
tion companies,  the  receiver  makes  very  few  changes  in  the 
personnel  of  his  organization,  although  he  may  alter  entirely 
the  general  policy  of  the  corporation  in  many  important  con- 
tracts.     For   permission   to   enter   into    or   cancel    important 


308  CORPORATION  FINANCE  [XX^ 

contracts,  a  receiver  will  usually  seek  the  consent  of  the  court ; 
he  must  also  obtain  permission  of  the  court  in  order  to  issue 
receiver's  certificates  and  to  expend  large  sums  for  the  im- 
provement of  the  property.  But  in  all  details  of  actual  manage- 
ment the  receiver  is  free  to  follow  his  own  judgment. 

Investigations  Succeeding  Receivership. — During  this 
period,  while  the  receiver  is  in  actual  control  of  the  property 
of  the  corporation,  the  various  committees  are  at  work  seeking 
to  find  a  substantial  basis  upon  which  to  establish  their  plan 
of  reorganization.  This  requires  a  knowledge  of  at  least 
three  sets  of  facts. 

First,  they  must  ascertain  by  competent  auditors  whether 
or  not  the  published  reports  of  the  corporation  in  the  years 
preceding  the  failure  were  approximately  true.  The  audit 
must  not  only  verify  the  technical  correctness  of  the  books, 
but  it  must  also  determine  whether  or  not  the  depreciation 
accounts  were  adequate,  and  if  they  were  not — as  was  prob- 
ably the  case — the  extent  of  the  deficiency.  The  auditors 
must  also  ascertain  whether  or  not  all  the  equipment — ma- 
chinery, merchandise,  or  rolling  stock — claimed  to  be  in  fit 
"usable"  condition,  is  actually  in  use  or  in  fit  condition;  they 
must  check  all  the  rentals,  insurance  policies,  and  intercompany 
contracts  to  be  sure  that  the  old  managers  have  protected  the 
company's  contractual  rights. 

The  second  set  of  facts  is  supplied  by  attorneys,  acting 
for  the  reorganization  committee.  They  have  to  do  with 
countless  legal  matters  resulting  from  the  general  tangle : 
what  contracts  may  be  safely  abrogated  and  what  contracts 
must  be  fulfilled  even  at  temporary  losses,  the  amounts  re- 
quired to  settle  with  parties  holding  contingent  claims  in  order 
to  forestall  troublesome  delays,  the  probable  outcome  of 
pending  suits,  and  the  approximate  expenses  of  the  receiver- 
ship and  reorganization. 


XXV]  REORGANIZATION  METHODvS  309 

A  third  set  of  facts  the  reorganization  committees  must 
supply  themselves,  and  since  there  are  among  their  number 
distinguished  bankers,  they  require  no  independent  expert 
advice.  These  facts  cover  the  general  probability  for  the 
successful  negotiation  and  sale  of  the  securities  of  the  re- 
organized road.  The  committees  must  assess  accurately  the 
probable  effect  of  their  reorganization  plan  on  the  market 
values  of  old  and  new  securities;  they  must  determine  the  limit 
of  sacrifice  stockholders  will  make  without  surrendering  their 
interests,  the  relative  marketability  of  long-  and  short-term 
bonds,  the  expenses  and  fees  of  underwriters,  and  similar 
financial  matters. 

Formation  of  the  Reorganization  Plans. — From  the  re- 
sults of  these  investigations  the  general  committee  works  out 
a  single  reorganization  plan  which  is  based  on  the  most  accu- 
rate and  comprehensive  knowledge  available.  No  definite  plan 
is  now  advanced  in  haste.  But  this  orderly  procedure  has 
developed,  however,  only  within  the  last  twenty  years. 
Formerly  plans  were  propounded  by  one  committee  after 
another,  beginning  almost  as  soon  as  the  rumors  of  the  impend- 
ing disaster  were  heard.  In  contrast  to  the  reorganizations 
before  1900,  it  may  therefore  be  said  that  the  contemporary 
practice  is  to  lengthen  the  period  of  preliminary  investigation 
and  adjustment,  during  which  time  no  reorganization  plan  is 
published,  and,  so  far  as  possible,  to  shorten  the  period  of 
public  discussion  over  the  plan  through  a  preliminary  agree- 
ment on  the  part  of  all  the  influential  interests  to  support  the 
final  plan  as  soon  as  it  is  published.  Practically  all  the  recent 
reorganizations  of  large  corporations  have  run  along  smoothly 
in  an  orderly  manner,  to  outward  appearances.  The  Chicago, 
Rock  Island  and  Pacific,  the  St.  Louis  and  San  Francisco,  the 
Pere  Marquette — all  of  them  reorganizations  of  railroads 
involving  a  multitude  of  conflicting  interests — were  consum- 


310  CORPORATION  FINANCE  [XXV 

mated  without  apparent  external  friction,  once  a  definite  and 
final  plan  had  been  agreed  to  secretly  by  the  various  committees 
which  represented  the   important   securities. 

The  most  difficult  and  important  step  in  the  reorganization 
procedure  is  to  secure  a  complete  outward  harmony  of  all  im- 
portant interests,  so  that  all  may  work  for  the  success  of  a 
common  plan.  All,  except  perhaps  the  senior  bondholders, 
must  make  some  sacrifices.  But  the  determining  power  lies 
usually  with  the  committee  representing  those  securities — 
usually  the  junior  mortgage  bonds  or  debentures — of  which 
some  sacrifice  is  required,  but  which  is  nevertheless  in  a  rela- 
tively secure  position  as  compared  with  the  holders  of  the 
floating  debt  and  the  stocks.  In  other  words,  the  determina- 
tion of  the  plan  is  likely  to  be  left  to  the  factions  which  must 
make  sacrifices.  Of  these,  the  party  making  the  least  sacri- 
fice will  probably  have  the  deciding  voice. 

Out  of  the  conflict  of  opinions  and  interests,  a  plan  of  re- 
organization is  finally  evolved  which  has  the  acknowledged 
support  of  all  the  committees  representing  the  conflicting  in- 
terests. This  plan  is  published  before  the  receiver  surrenders 
the  property,  or  even  before  the  foreclosure  sale.  It  is  pub- 
lished with  the  recommendation  of  all  the  committees  that  it 
be  accepted  by  the  various  groups  of  security-holders.  The 
latter  are  asked  to  become  parties  to  the  "reorganization 
agreement,"  which  is  the  formal  legal  document  that  invari- 
ably accompanies  "the  plan."  By  so  doing,  they  assent  to  the 
terms  of  the  reorganization  and  on  paying  their  assessment, 
if  any  is  called  for,  receive  their  allotted  securities  in  the  new 
corporation.  Those  who  do  not  care  to  accept  the  terms  of 
the  reorganization  are  allowed  to  withdraw  the  securities 
originally  deposited,  usually  on  the  payment  of  a  small  fee 
to  cover  expenses  of  the  committee.  If,  as  is  probably  the 
case,  a  very  large  proportion  of  the  security-holders  consent 
to  the  conditions,  the  reorganization  committee  declares  the 


XXV]  REORGANIZATION  METHODS  311 

plan  operative,  and  the  reorganization  is  finished  except  for 
the  legal  formalities. 

Execution  of  the  Plan. — To  carry  out  the  obvious  will  of 
the  great  majority  of  assenting  claimants  and  security-holders, 
the  reorganization  must  be  forced  through  and  the  dissenting 
minority  and  obstructionists  settled  with  in  a  just  and  open 
xTianner  fully  approved  by  the  court.  This  is  accomplished 
by  the  judicial  sale  of  the  old  corporation's  property  through 
a  decree  of  foreclosure,  by  which  the  court  preserves  the  out- 
ward form  of  a  foreclosure  sale.  Owing  to  the  fact  that  the 
foreclosure  of  the  property  of  a  great  corporation  requires  far 
more  capital  than  a  single  man  or  group  of  men  can  command, 
the  court  recognizes  that  there  will  be  no  competition  at  the 
foreclosure  sale  of  the  property.  In  order  to  prevent  the 
various  parties  who  have  agreed  among  themselves  upon  a 
workable  plan  of  reorganization  from  conspiring  together  to 
purchase  the  property  for  little  and  thus  defeat  the  just  claims 
of  other  creditors  who  have  not  pooled  their  interests,  the 
court  ordinarily  fixes  a  minimum  or  "upset"  price.  It  is  the 
amount  which  the  receivers  must  realize  from  the  property 
in  order  that  the  court  shall  confirm  the  sale.  It  amounts, 
practically,  to  the  determination  by  the  court  of  the  price  at 
which  the  reorganization  committee  may  acquire  the  prop- 
erty of  the  old  corporation  at  a  public  sale,  and  also  of  the 
conditions  under  which  the  committee  must  settle  with  the 
creditors  who  have  not  consented  to  its  plan.  There  is, 
theoretically  at  least,  a  chance  that  other  persons  may  care  to 
pay  more  for  the  property  than  the  reorganization  committee, 
and  the  general  creditors  not  embraced  in  the  committee's 
plan  should  be  given — theoretically  at  least — an  opportunity 
to  bid  in  the  property  in  satisfaction  of  their  own  liens. 

The  reorganization  committee,  having  acquired  the  prop- 
erty, immediately  turns  it  over  to  the  new  corporation.     This 


312  CORPORATION  FINANCE  fXXV 

the  committee  has  caused  to  be  formed  even  before  the  final 
settlement.  The  same  name  is  retained  in  the  case  of  reorgani- 
zation of  a  pubHc  service  corporation,  except  that  "railroad" 
may  be  changed  to  "railway"  or  "company"  to  "corporation." 
But  in  the  case  of  industrials  the  name  of  the  new  corporation 
is  almost  invariably  made  different  from  the  old  one. 

Adjustment  of  Opposing  Interests. — The  most  difficult 
problem  remaining  to  the  reorganization  committee  after  the 
sale  is  that  of  the  final  adjustment  of  conflicting  interests.  The 
questions  connected  with  this  problem  have  been  affecting 
all  the  tentative  plans  and  later  stages  of  the  work  of  the 
various  reorganization  committees.  They  represent  the  loose 
ends  and  possible  sources  of  embarrassment  and  litigation 
that  invariably  cast  their  shadows  about  every  reorganization 
of  importance.  In  case  all  the  bonds  are  of  one  class,  are  all 
deposited  with  the  reorganization  committee,  and  no  other 
creditors  exist,  the  transition  from  control  by  the  receivers 
to  that  of  the  new  corporation  occurs  without  a  possibility  of 
friction.  But  such  simplicity  is  seldom  if  ever  present  in  any 
reorganization  of  considerable  size.  There  are  always  claims 
to  be  adjusted.  If  the  upset  price  exceeds  the  face  value  of 
one  or  more  issues  of  underlying  bonds,  these  bonds  are  not 
affected;  in  the  vocabulary  of  finance  they  are  "undisturbed." 
If  the  upset  price  does  not  equal  the  face  value  of  a  bond 
issue,  some  adjustment  is  necessary  with  those  of  the  bond- 
holders who  have  not  consented  to  enter  the  reorganization 
and  they  are  invariably  paid  off  in  money  raised  by  the  re- 
organization committee  as  part  of  their  plan.  The  amount 
each  non-assenting  bondholder  receives  is  the  proportional 
part  the  face  value  of  his  bond  bears  to  the  sum  received  by 
the  court  from  the  sale  of  the  actual  property  securing  them. 
Unless  the  bonds  are  secured  by  very  valuable  physical  prop- 
erty the  amount  given  the  non-assenting  bondholders  is  small 


CHAPTER  XXVI 

RAILROAD   REORGANIZATIONS 

Overexpansion  as  a  Cause  of  Failure. — Great  emphasis 
has  been  laid  already  on  the  frequency  of  overexpansion  as 
a  cause  of  corporate  failure.  This  importance  cannot  well 
be  overemphasized  in  discussing  railroad  failures.  In  the 
very  earliest  days  of  railroad  building  this  evil  showed  itself 
in  the  extension  of  railroads  into  well-developed  territory  with- 
out measuring  the  cost  of  construction;  during  the  third 
quarter  of  the  last  century  it  took  the  form  of  extension  into 
territory  insufficiently  developed,  economically,  to  maintain 
a  railroad.  Subsequently,  failure  has  resulted  from  the  over- 
building of  branch-line  feeders  in  the  hope  of  "creating"  new 
traffic.  Still  more  recently  railroad  systems  have  been  afflicted 
by  a  weakness  incident  to  mere  size,  such  as  combination  of 
several  groups  into  single  vast  systems  or  even  (as  has  been 
true  many  times)  the  embarkation  of  the  railroad  in  other 
remotely  connected  industries.  With  this  overexpansion  the 
business  as  a  whole  earned  a  steadily  declining  rate  of  return 
on  the  average  unit  of  investment.  It  became  thinner,  through 
a  rather  rigid  application  to  the  railroad  industry  of  a  kind  of 
diminishing  return  on  capital  investment.  As  large  amounts 
of  money  were  required  to  meet  the  costs  of  extensions,  over- 
expansion  of  a  railroad  was  accompanied  almost  inevitably 
by  an  increase  in  the  funded  debt,  both  relatively  to  the  total 
invested  capital  and  absolutely  per  mile  of  railroad.  Two  ten- 
dencies, therefore,  operated  at  the  same  time,  a  decrease  in 
earnings  and  an  increase  in  the  interest  payments  required  by 
the  funded  debt.  Ultimately  the  interest  charges  exceeded 
the  earnings  and  the  company  failed.     But  this  failure  was 

313 


314  CORPORATION  FINANCE  [  XXVI 

invariably  postponed  by  the  operation  of  palliatives — first  the 
expenditures  for  maintenance  were  cut  to  the  marrow,  and 
then  a  large  floating  debt  was  piled  up. 

Purposes  of  Reorganization — i.  Reduction  of  Fixed 
Charges. — In  view  of  these  generalizations,  surprisingly  free 
from  exceptions,  if  one  considers  the  variety  of  origin,  location, 
and  administration  of  our  railroads,  it  is  possible  to  observe 
that  every  railroad  reorganization  must  penetrate  beneath  the 
tangle  of  proximate  causes  and  either  lop  off  the  wasting 
parasitic  growths  resulting  from  overexpansion,  or  else  so 
remold  the  financial  plan  of  the  railroad  that  the  interest 
charges  shall  be  less,  not  greater,  than  the  net  earnings.  Fre- 
quently the  reorganization  plan  has  involved  a  reduction  in 
mileage,  especially  in  those  cases  of  most  obvious  overexpan- 
sion. Although  this  may  be  a  tacit  admission  of  previous  mis- 
takes, the  old  management  invariably  ascribes  the  failure  to 
superficial  rather  than  ultimate  causes.  Consequently  the 
other  alternative,  that  of  recasting  the  financial  plan  so  that 
the  fixed  interest  charges  shall  lie  well  within  the  earnings,  is 
the  underlying  motive  of  every  reorganization.  About  this, 
every  other  feature  of  the  reorganization  turns.  It  is  felt  by 
all  concerned  that  failure  was  due  to  maladjustments  from 
rapid  expansion,  and  not  to  the  expansion  itself.  It  is  assumed 
therefore,  that  if  the  road  is  given  relief  from  its  overpower- 
ing burden  of  fixed  charges,  it  will  recover  its  poise.  Railway 
pioneers  in  earlier  days  and  railway  expansionists  in  the  last 
epoch  have  been  constitutionally  optimists;  they  prescribed 
merely  a  rest  for  their  patient — not  surgery.  The  history  of 
railroad  reorganization  practice,  as  we  shall  see  presently, 
has  been  the  history  of  a  gradual  realization  that  the 
rest,  to  be  permanently  curative,  must  be  accompanied  by 
surgery. 

Reduction  in  fixed  charges  was,  therefore,  the  primary 


XXVI]  RAILROAD  REORGANIZATIONS  315 

purpose  of  every  railroad  reorganization,  but  it  was  not  the 
only  purpose. 

2.  Collection  of  New  Money — It  has  been  stated  already 
that  a  railroad  on  the  verge  of  bankruptcy  can  postpone  the 
acknowledgment  of  its  failure  by  two  means — a  reduction  in 
the  expenses  necessary  to  maintain  the  physical  integrity  of 
the  road,  and  an  increase  in  the  amount  of  its  floating  debt. 
Both  means  are  adopted.  Consequently,  when  failure  is 
finally  admitted  through  the  appointment  of  a  receiver,  the 
court  finds  the  road  very  much  out  of  repair  because  of  in- 
sufficient maintenance  expenditures,  and  heavily  weighed  down 
by  a  burden  of  floating  debt. 

Formerly  the  rehabilitation  of  the  road  and  the  liquida- 
tion of  the  floating  debt  were  allowed  to  wait  until  the  period 
of  reorganization;  but  of  recent  years  courts  have  permitted 
receivers  to  borrow  money  on  their  own  certificates  for  these 
purposes.  In  any  event  the  plan  of  reorganization  must  pro- 
vide sufficient  money  either  to  rehabilitate  the  road  and  pay 
its  prereceivership  debts  directly,  or  else  to  pay  the  receivers' 
certificates  which  had  been  sold  for  the  purpose  of  accomplish- 
ing these  ends  during  the  receivership.  Ample  new  money, 
then,  under  any  circumstances,  is  the  second  essential  purpose 
of  every  railroad  reorganization.  And  since  the  credit  of 
the  bankrupt  property  is  low,  both  because  of  its  previous 
history  and  the  notoriety  given  to  it  by  the  fact  of  a  receiver- 
ship, outside  investors  will  not  buy  its  securities.  The  new 
money  must  be  extracted  from  the  old  stockholders,  who  are 
the  only  persons  sufficiently  interested  in  the  property  to  make 
sacrifices  to  help  it  in  its  hour  of  need. 

While  these  two  purposes,  the  collection  of  new  money 
from  old  security-holders  and  a  reduction  in  fixed  charges, 
have  been  the  paramount  issues  in  every  railroad  reorganiza- 
tion, they  have  not  been  accomplished  by  the  same  means. 


3l6  CORPORATION  FINANCE  [XXVI 

This  is  what  makes  the  analysis  of  railroad  reorganization 
difficult  if  one  stresses  the  means  employed  rather  than  the 
ends  achieved.  On  the  other  hand,  since  the  ends  to  be 
achieved  are  so  strikingly  uniform,  we  can  define  a  railroad 
reorganization  as  a  comprehensive  change  of  the  financial 
plan,  necessitated  by  impending  or  actual  failure,  such  that 
the  fixed  charges  are  reduced  and  new  money  is  supplied 
through  the  sacrifices  of  security-holders. 

Principles    and    Practice    of    Railroad    Reorganization. — 

Principles  of  reorganization  practice  were  thoroughly  estab- 
lished by  the  thoroughgoing  and  drastic  reorganizations  of 
the  large  railway  systems  during  the  middle  nineties,  and  these 
principles  were  applied  with  uniform  precision  to  the  recent 
cases.  Omitting,  for  the  purpose  of  this  introductory  survey, 
confusing  exceptions  and  unimportant  details,  one  may  sum- 
marize contemporary  reorganization  practice  in  the  following 
general  terms : 

So  far  as  the  formal  procedure  is  concerned,  a  reorgani- 
zation brings  about  an  adjustment — represented  usually  by 
a  compromise — between  the  strict  construction  of  the  legal 
obligations  of  the  various  security-owners  and  creditors  of  the 
road,  and  the  necessity,  from  the  public  point  of  view,  that 
the  railroad  maintain  its  service  as  a  solvent,  responsible,  and 
progressive  corporation.  It  is  the  balance  between  private 
and  public  interests.  While  pretending  to  hold  to  the  strict 
construction  of  the  legal  contract,  the  courts  have  been  inclined 
to  allow  all  interests,  no  matter  what  their  equitable  rights 
might  be,  to  participate  in  the  reorganization,  provided  an  im- 
proved railroad  service  can  be  promised  to  the  public.  Neither 
state  nor  federal  laws  have  much  to  do  with  determining  the 
character  of  railroad  reorganization.  The  parties  most  con- 
cerned are  encouraged  to  work  out  any  plan  that  is  expedient 
and.  approximately  just  provided  it  is  socially  and  economi- 


XXVI]  RAILROAD  REORGANIZATIONS  31? 

cally  sound.  And  the  resulting  compromise  between  the 
strict  rights  of  the  bondholders,  the  blasted  hopes  of  the  stock- 
holders, and  the  welfare  of  the  public,  is  based  on  expediency 
tempered  by  justice  rather  than  justice  tempered  by  expedi- 
ency. It  is  carried  through  under  the  sanction  of  a  system 
of  law  which  has  grown  up  as  a  response  to  the  peculiar 
economic  conditions  of  a  new  country,  a  system  of  law  which 
has  sought  to  preserve  the  forms  of  a  legal  practice  existing 
long  before  railroads  were  conceived,  while  modifying  its 
substance  to  meet  the  actual  conditions  of  railroad  success 
and  failure  in  this  country. 

So  far  as  the  specific  results  are  concerned,  the  present 
practice  rests,  as  has  been  previously  suggested,  on  the  elemental 
principle  that  two  primary  ends  must  be  achieved  in  every 
railroad  reorganization.  The  more  immediate,  but  less  funda- 
mental, is  the  collection  of  a  fund  of  money,  obtained  primarily 
by  a  levy  on  the  stockholders,  out  of  which  to  pay  the  accumu- 
lated debt  at  the  time  of  the  receivership,  the  improvements  of 
the  road  during  receivership,  and  the  expenses  of  reorganiza- 
tion; and  finally  to  provide  the  means  that  shall  keep  the  re- 
organized road  from  incurring  new  floating  debt  during  the 
period  of  its  rehabilitation.  The  second  end  is  the  reduction 
in  fixed  charges.  The  letter  of  the  railroad  mortgage  bond 
has  come  to  be  nothing  more  than  mere  legal  verbiage,  but  if 
the  property  covered  by  the  mortgage  has  earned  its  charges 
the  mortgage  is  allowed  to  remain  and  the  bondholders  are 
not  asked  to  make  sacrifices.  If  on  the  other  hand,  the  prop- 
erty behind  the  mortgage  has  failed  to  earn  its  charges  the 
bondholders  are  forced  to  accept  a  lessening,  perhaps  a  total 
extinction,  of  their  right  to  demand  a  fixed  income.  They 
may  object,  but  they  are  powerless  to  resist,  except  by  acquir- 
ing the  actual  property  itself  at  foreclosure  sale;  and  the  failure 
of  their  property  to  earn  its  charges  prior  to  the  receivership 
gives  little  promise  that   its  earnings  would  be  better  after 


3. 1 8  CORPORATION  FINANCE  [XXVI 

the  bondholders  themselves  have  exercised  the  letter  of  their 
legal  rights  and  acquired  by  themselves  alone  the  actual  opera- 
tion of  the  road.  We  have  here  another  illustration  of  the 
fundamental  truth  that  the  economic  value  of  physical  property 
is  no  greater  than  its  inherent  earning  capacity. 

The  Reorganization  Plan. — The  syndicate  of  bankers  that 
is  called  into  existence  to  finance  the  reorganization  will  prob- 
ably dictate  the  plan.  Normally  the  plan  will  provide  for  the 
formation  of  a  new  corporation  which  shall  take  over  the 
assets  of  the  old  one,  subject  to  such  underlying  liens  as  are 
not  affected  by  the  reorganization.  The  syndicate  is  then  in 
a  position  to  issue  entirely  new  securities  which  are  superior  to 
every  liability  of  the  old  corporation  except  the  undisturbed 
prior  lien  bonds.  Such  new  securities  are  ordinarily  of  three 
classes.  They  may  be  designated  as  the  fixed  charge,  the  con- 
tingent charge,  and  the  common  stock  securities.  The  first 
class  will  consist  of  a  large  issue  of  general  mortgage  bonds 
having  a  small  interest  rate,  the  aggregate  of  which  is  less  than 
the  net  earnings  of  the  railroad  during  the  receivership.  The 
second  class  will  be  income  bonds  or  non-cumulative  preferred 
stock — preferably  the  latter — the  interest  or  dividend  payments 
of  which,  together  with  the  interest  on  the  other  bonds,  will 
bring  the  capital  charges  to  an  amount  somewhat  less  than  the 
maximum  income  prior  to  receivership.  The  third  class  will 
be  the  common  stock,  large  in  amount,  but  having  no  fixed  or 
contingent  charge.  It  is  distributed  freely  in  order  to  placate 
the  old  security-holders. 

The  plan  will  propose  as  well  to  secure  new  money  in  order 
to  pay  the  floating  debt,  the  receivers'  certificates,  and  to  im- 
prove the  physical  property  of  the  road.  This  new  money  will 
come  from  two  independent  sources.  A  syndicate  will  pur- 
chase of  the  new  corporation  a  block  of  the  new  general 
mortgage  bonds.     The  holders  of  the  stock  and  possibly  the 


XXVI]  RAILROAD  REORGANIZATIONS  319 

junior  bonds  of  the  old  corporation  will  be  taxed  or  assessed 
as  much  as  they  can  be  induced  to  pay  for  the  privilege  of  ac- 
quiring a  subordinate  interest  in  the  new  corporation.  This 
participation  is  usually  represented  by  a  combination  of  con- 
tingent charge  securities  and  common  stock.  To  assure  the 
new  road  the  proceeds  of  these  assessments,  the  syndicate  which 
has  undertaken  to  buy  a  part  of  the  issue  of  general  mortgage 
bonds  will  probably  agree  to  pay  the  assessment  demanded  of 
any  delinquent  stockholder  and  assume  his  rights  in  the  new 
corporation. 

The  same  idea  can  be  restated  in  the  uses  to  which  the 
three  new  classes  of  securities  are  put.  The  bonds  involving 
fixed  charges  are  given  in  exchange  for  a  part  or  all  of  those 
of  the  old  bonds  upon  which  it  can  justly  be  claimed  that  the 
interest  was  earned  and  will  be  earned  under  all  circumstances. 
The  rest  are  sold  to  the  syndicate  for  money.  The  securities 
bearing  contingent  charges,  together  with  the  common  stock, 
are  given  in  varying  combinations  to  the  holders  of  those  old 
bonds,  the  interest  on  which  had  not  been  fully  earned,  and  to 
the  stockholders,  on  condition  of  the  payment  of  a  certain  tax 
or  assessment.  As  a  result  of  these  transformations  the  almoFt 
invariable  consequence  of  every  railroad  reorganization  since 
1895  has  been  that  the  road  emerged  from  its  troubles  with  a 
lower  fixed  charge  against  income  but  with  a  higher  total 
capitalization.  The  bonds  and  the  fixed  interest  charges  are 
reduced;  but  the  par  value  of  the  preferred  and  common  stocks 
is  increased,  by  reason  of  the  necessity  of  distributing  these 
securities  freely  in  return  for  the  sacrifices  made  by  the  old 
junior  bondholders  and  stockholders.  We  are  thus  presented 
with  the  striking  anomaly  that  the  bankruptcy  of  a  railroad 
corporation  leads  to  a  direct  increase  of  its  total  issued  securi- 
ties. We  are  also  presented  with  the  even  more  striking  fact 
that  in  the  presence  of  financial  failure  the  public  service  char 
acter  of  a  railway  corporation  is  most  clearly  shown. 


320  CORPORATION  FINANCE  [XXVI 

Classification  of  Railroad  Failures  and  Reorganizations. — 
This  brief  outline  of  the  form  of  contemporary  railroad  re- 
organization is  altogether  too  general  and  superficial  to  be  of 
significance  when  applied  to  concrete  cases.  All  railroads 
differ  among  themselves.  The  specific  causes  of  railway  failure 
^re  never  the  same  in  two  instances,  so  that  the  specific  remedies 
to  be  applied  will  necessarily  vary  according  to  the  individual 
case.  Consequently,  in  order  to  discuss  reorganization  plans 
in  any  except  the  most  general  terms,  and  to  treat  of  the  sub- 
ject with  clearness  and  definiteness  of  outline,  it  is  necessary 
to  arrange  railroad  reorganizations  themselves  according  to 
some  kind  of  system  of  classification,  else  any  detailed  discus- 
sion of  the  subject  degenerates  into  a  mere  jargon  of  unordered 
cases.  But  a  classification  of  railway  reorganizations  is  diffi- 
cult, owing  to  the  difficulty  of  determining  a  proper  system. 

From  all  points  of  view,  the  most  valuable  way  of  classify- 
ing railroad  reorganizations  themselves  (and  the  practical  ex- 
pedients used  in  accomplishing  the  two  primary  ends),  is  in 
terms  of  the  causes  and  extent  of  the  embarrassment  which 
occasioned  the  necessity  of  reorganization.  In  other  words, 
reorganizations  are  best  classified  according  to  their  causes. 
Financial  embarrassment,  actual  or  threatened,  is  the  cause 
of  the  crisis  of  which  reorganization  is  the  remedy.  A  re- 
organization, therefore,  can  be  successfully  consummated  only 
as  it  removes  the  cause,  so  that  any  attempt  at  classification 
must  recognize  that  the  form  as  well  as  the  concrete  details  of 
railway  reorganizations  will  vary  according  to  the  nature,  ex- 
tent, and  seriousness  of  the  failures  which  caused  them. 

There  are,  in  general,  three  types  of  railway  failures — two 
pertaining  to  large  railway  systems,  the  third  confined  to  small 
independent  railroads. 

I.  Primary  Failures. — The  first  type,  which  we  will  here- 
after call  "primary  failures"  and  the  resulting  reorganizations, 


XXVI]  RAILROAD  REORGANIZATIONS  3^1 

"primary  reorganizations,"  or  class  i,  is  the  result  of  a  crisis 
which  is  serious,  thoroughgoing,  and  usually  long  protracted. 
This  class  embraces  the  real  financial  and  economic  failures  of 
our  large  railways.  In  the  actual  experience  of  a  particular 
case  one  may  assume  that  the  crisis  has  been  coming  on  for 
many  years.  Various  palliatives  have  been  applied.  Various 
expedients  have  been  tried;  not  infrequently  some  expedient 
has  even  approached  the  scope  of  a  reorganization.  Every 
known  device  of  economy  of  operation  has  been  tested. 
Usually  the  railway  system  has  been  overextended  into  new 
or  competing  territory  in  the  hope  of  increasing  the  stability 
of  net  earnings  through  increased  gross  revenue.  Ordinarily, 
every  available  prop  in  the  way  of  association  and  combination 
has  been  tried  to  increase  the  available  net  earnings;  every 
known  financial  device  of  lease  and  guaranty,  of  collateral 
trust  bond,  debenture,  and  short-term  note,  has  probably  been 
resorted  to  in  order  to  secure  money  and  bolster  up  a  declining 
credit.  All  these  expedients  are  at  most  mere  palliatives.  They 
avail  nothing.  The  net  earnings  continue  to  decline ;  the  l)ond 
interest  and  rentals  increase  more  rapidly  than  the  earnings. 
The  margin  available  to  the  stockholders  grows  narrower  and 
narrower,  and  the  credit  poorer  and  poorer.  Such  conditions 
are  fundamental.  Yet  as  the  current  liabilities  of  a  railroad  are 
always  relatively  small  and  its  floating  debt  is,  or  ought  to  be, 
insignificant  compared  with  its  total  capitalization,  the  con- 
ditions described  may  continue  for  some  time  before  a  specific 
crisis  brings  about  an  outward  acknowledgment  of  failure. 
The  important  consideration,  however,  is  that  the  railway 
system  as  a  whole  is  a  failure  economically.  Its  earning  capac- 
ity cannot  justify  its  capitalization. 

2.  Secondary  Failures. — The  second  class,  called  hereafter 
"secondary  failures"  and  the  reorganizations  "secondary  re- 
organizations," or  class  2,   embraces  those   railroad   failures 


322  CORPORATION  FINANCE  [XXVI 

which  cannot  be  called  fundamental.  The  earnings  for  a  few 
years  past  may  have  fallen  off ;  bad  crops,  floods,  or  strikes  in 
the  principal  industries  may  have  produced  conditions  seriously 
affecting  the  gross  receipts,  while  the  operating  expenses  and 
fixed  charges  remained  the  same ;  short-term  notes  or  a  matur- 
ing bond  issue  may  have  created  financial  embarrassment.  At 
all  events,  a  crisis  occurs  and  the  railroad's  credit  cannot  with- 
stand it.  Failure  results.  But  the  causes  underlying  it  are 
not  fundamental.  And  the  remedies  that  need  be  applied  are 
neither  as  comprehensive  nor  as  radical  as  is  necessary  with 
failures  of  the  primary  type. 

3.  Failures  of  Small  Lines. — The  third  type,  class  3,  per- 
tains to  small,  unimportant,  often  unfinished  lines  of  railway. 
Sometimes  the  existence  of  the  road  was  unjustified  by  the 
volume  of  traffic.  Sometimes  the  road  was  built  merely  for 
strategic  purposes.  Sometimes  the  road  was  so  grossly  over- 
capitalized and  mismanaged,  during  the  construction  period, 
that  it  became  insolvent  before  it  was  born.  At  all  events  the 
railroad  is  a  thoroughgoing  failure.  But  this  failure,  due  to 
the  absence  of  its  obvious  public  necessity,  is  not  of  great 
economic  significance.  Its  securities  are  probably  closely  held 
and  the  failure  is  not  confessed  until  the  last  phantom  of  its 
credit  has  vanished.  In  the  restricted  and  local  significance  of 
their  undertakings,  and  in  the  extent  and  thoroughness  of  their 
distress,  the  failures  of  these  little  local  lines  resemble  the 
failures  of  small  local  industrial  enterprises.  Failures  of  this 
kind  are  hereafter  called  those  of  the  third  class. 

Primary  Reorganizations. — Reorganization  plans  and  ex- 
pedients follow  closely  this  classification  of  railway  failures. 
The  reorganization  of  a  railway,  the  failure  of  which  is  of  the 
first  class,  is  thorough,  comprehensive,  and  radical.  Practi- 
cally all  securities,  even  small  underlying  closed  first  mortgage 


XXVI]  RAILROAD  REORGANIZATIONS  323 

bond  issues,  are  refunded.  And  while  the  holders  of  these 
underlying  bonds  are  not  ordinarily  asked  to  endure  any 
sacrifices,  they  are  asked  to  refund  their  variety  of  divisional 
issues  into  a  single  comprehensive  first  mortgage  bond  issue 
covering  the  entire  railway  system.  Ordinarily  the  interest 
rate  on  this  single  issue  is  lower  than  the  average  rate  on  the 
small  issues  which  it  refunds,  so  that  it  is  often  necessary  to 
increase  the  principal  or  add  a  complement  of  junior  securities 
in  order  to  placate  these  old  bondholders.  The  holders  of 
junior  bonds,  provided  the  interest  on  them  can  be  earned 
unquestionably,  are  usually  given  bonds  of  a  "general"  or  re- 
funding issue.  All  other  bonds,  upon  which  little  or  nothing 
was  earned  in  the  years  before  the  failure,  are  forced  to  take  a 
preferred  stock  in  the  new  company.  The  old  preferred  and 
common  stocks  are  assessed,  and  ofifered  new  preferred  and 
common  stock.  As  a  result  of  these  changes  a  complex  financial 
situation,  involving  a  multitude  of  small  divisional  issues, 
followed  by  several  layers  of  nondescript  bonds,  followed  in 
turn  by  notes  and  preferred  and  common  shares,  is  simplified 
and  standardized.  There  are  one  or  two  senior  issues  of  bonds, 
one  issue  of  preferred  stock,  and  one  of  common.  Considerable 
amounts  of  new  money  are  added  through  stockholders'  assess- 
ments; the  fixed  charges  are  reduced  by  the  refunding  of  the 
old  underlying  and  first  mortgage  bonds  into  one  or  two  issues 
of  new  low-interest-rate  bonds,  and  by  refunding  the  junior 
bonds  into  preferred  stock.  The  reorganization,  like  the  failure 
it  follows,  is  penetrating,  drastic,  and  comprehensive. 

These  principles  can  be  understood  from  the  detailed  study 
of  the  refunding  operation  in  one  of  the  recent  comprehensive 
reorganizations,  that  of  the  Pere  Marquette  Railroad  in  the 
autumn  of  191 6.  In  this  reorganization  all  of  the  underlying 
and  divisional  bonds  were  refunded  into  a  single  issue  of 
general  first  mortgage  bonds — part  of  which  bore  5  per  cent 
interest  and  part  4  per  cent.     There  were  in  all  1 1  separate 


324 


CORPORATION  FINANCE 


[XXVI 


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issues  of  underlying  and  divisional  bonds,  aggregating 
$26,314,000  and  carrying  fixed  charges  to  the  amount  of 
$1,275,160,  or  an  average  of  4.8  per  cent.  These  11  issues 
occupied  very  different  strategic  positions,  both  with  respect 
to  the  status  of  their  lien  and  the  geographical  position  of  the 
section  of  the  railway  securing  them.  The  earning  capacity  of 
the  branch  lines  varied  also.  With  these  differences  it  is  pos- 
sible to  classify  these  11  issues  into  the  three  classes  described 
in  an  earlier  paragraph. 

As  a  result  of  the  process  of  refunding,  the  principal  of 
these  underlying  and  divisional  issues  was  reduced  by  almost 
$5,000,000  and  the  fixed  interest  charge  from  $1,275,160  to 
$982,140 — a  reduction  in  charges  of  over  22  per  cent. 

Secondary  Reorganizations. — Reorganizations  following 
failures  of  the  second  class  are  superficial  compared  to  those 
described  in  the  previous  paragraph.  As  the  failure  is  not 
fundamental,  a  radical  readjustment  of  the  financial  structure 
is  neither  necessary  nor  advisable.  Accordingly,  no  attempt  is 
made  to  disturb  more  than  the  stocks  and  junior  bonds,  and  no 
radical  sacrifice  is  demanded  of  any  security-holder.  In  many 
cases  thewhole  reorganization  turns  on  the  willingness  of  the 
holders  of  some  large  overlying  issue  of  refunding  bonds,  notes, 
or  debentures  to  refund  these  into  preferred  stock  or  income 
bonds,  bearing  the  same  nominal  investment  return.  The 
charges  on  the  junior  bonds  become  contingent  instead  of  fixed. 
In  return  for  this  sacrifice  from  the  junior  bondholders,  the 
stockholders  consent  to  an  assessment,  receiving  in  return 
securities  of  relatively  high  value.  As  a  whole,  such  a  re- 
organization disturbs  a  comparatively  small  number  of  securi- 
ties, and  these  are  only  the  uppermost  layers  of  the  financial 
structure.  The  failure  is  not  serious  and  a  serious  remedy 
is  not  required. 

In  a  reorganization  of  this  class  the  underlying  and  first 


XXVI]  RAILROAD  REORGANIZATIONS  32? 

mortgage  bonds  are  in  no  way  affected.  The  railroad,  both  in 
the  period  before  the  crisis  and  during  the  receivership,  fully 
earned  the  interest  on  these  bonds.  But  this  is  not  true  of  the 
junior  securities.  The  interest  on  these  was  not  earned  and  the 
necessity  of  paying  it  precipitated  the  crisis.  At  this  level,  and 
only  here,  it  is  expedient  and  just  to  demand  a  sacrifice.  Ac- 
cordingly, the  holders  of  these  junior  bonds  are  asked  to  refund 
them  into  contingent  charge  securities — income  bonds  or  pre- 
ferred stock.  This  involves  the  total  extinction  of  the  obliga- 
tory interest.  These  junior  bonds,  together  with  the  stocks, 
are  the  only  securities  disturbed  in  a  reorganization  of  this 
kind.  And  the  new  preferred  stocks  or  income  bonds  given  in 
exchange  are  quite  as  valuable  as  the  old  junior  bonds,  con- 
sidering the  decreased  earnings  of  the  road,  so  that  little  real 
sacrifice  is  asked  of  any  of  the  bondholders. 

Within  recent  years  there  have  been  three  typical  reorgani- 
zations of  this  class  among  important  railroad  systems.  They 
were  the  last  reorganization  of  the  Wabash  in  191 5  and  the 
reorganizations  of  the  Chicago,  Rock  Island  and  Pacific,  and 
the  Missouri  Pacific  in  191 7.  The  plan  adopted  was  exactly 
the  same,  except  for  individual  peculiarities  and  unimportant 
details.  The  underlying  and  divisional  bonds  were  undisturbed. 
In  each  case  the  decrease  in  fixed  charges  was  brought  about 
by  refunding  one  or  more  issues  of  junior  bonds  into  a  pre- 
ferred stock  having  a  position  just  one  step  inferior  to  the 
security  given  for  the  stockholders'  assessments.  That  is, 
the  uppermost  layer  of  bonds  was  refunded  into  a  medium- 
grade  stock.  Absolutely  nothing  was  done  to  disturb  any  of  the 
other  layers  of  bonds. 

Often,  among  failures  of  this  second  class,  the  conditions 
are  not  sufficiently  serious  to  warrant  even  a  forced  or  in- 
voluntary reorganization.  A  kind  of  "capital  adjustment"  is 
considered  sufficient,  the  object  of  which  is  merely  to  reduce 
or   extinguish   some   particularly   burdensome   fixed    charges. 


328  CORPORATION  FINANCE  [XXVI 

Often  in  such  cases  the  owners  of  the  upper  level  of  fixed  charge 
bonds  consent  to  exchange  them  for  an  income  bond  or  pre- 
ferred stock.  That  is  all  there  is  to  the  "adjustment" ;  a  fixed 
charge  on  a  portion  of  the  funded  debt  becomes  contingent  and 
the  immediate  occasion  of  bankruptcy  is  thereby  averted. 

Reorganization  of  Small  Railways. — Reorganizations  of 
railway  failures  of  the  third  class  are  exceedingly  drastic. 
The  little  road  has  been  bolstered  up  by  every  conceivable 
means.  Probably  when  it  failed  the  earnings  were  actually  less 
than  its  expenditure.  The  rolling  stock  and  roadbed  are  dilapi- 
dated. Consequently,  relatively  large  amounts  of  receivers' 
certificates  are  issued  immediately  in  order  to  maintain  the  road 
in  operation.  At  the  time  of  reorganization  these  must  be  paid. 
Yet  the  value  remaining  to  the  stockholders  is  so  slight  that 
they  will  not  endure  an  assessment  in  order  to  maintain  even 
their  shadow  of  an  equity.  As  a  result  the  full  brunt  of  the 
reorganization  falls  on  the  bondholders.  Ordinarily  there  is  a 
single  issue  of  bonds.  Accordingly,  the  holders  assess  them- 
selves to  pay  off  the  receivers'  certificates  and  to  furnish  the 
requisite  new  money.  In  efifect,  they  take  over  the  ownership 
of  the  road  from  the  old  stockholders.  In  some  instances  not 
only  the  stockholders'  interests  are  eliminated,  but  also  those 
of  all  the  bondholders,  and  the  road  is  taken  over  by  the  holders 
of  receivers'  certificates.  In  cases  of  complete  failure  the 
holders  of  the  receivers'  certificates  may  be  forced  to  assess 
themselves  to  maintain  the  operation  of  the  road. 

Increased  Capitalization. — It  has  been  pointed  out  by  all 
the  writers  on  railroad  finance  that  every  railroad  reorganiza- 
tion, at  least  until  the  last  few  years,  involved  an  increase  in 
the  nominal  amount  of  securities.  The  reason  was  that  in  order 
to  induce  the  holders  of  junior  bonds  and  stock  to  undergo 
sacrifices,  they  must  be  placated  by  liberal  bonuses  of  well- 


XXVI]  RAILROAD  REORGANIZATIONS  329 

nigh  worthless  junior  securities  of  the  new  road.  This  poHcy 
was  summed  up  some  few  years  ago  in  the  following  manner : 
As  a  result  of  the  shifting  of  securities  the  majority  of  railway 
companies  emerged  from  reorganization  burdened  by  an  in- 
crease in  capitalization.  Reorganization  acted  as  a  drug  to 
tide  over  a  period  of  weakness — the  future  was  mortgaged 
to  satisfy  the  present.  This  view,  perfectly  justified  by  the 
data  available  from  all  the  railroad  reorganizations  down  to 
1912  is  not  true  of  contemporary  reorganizations.  The  ten- 
dency since  19 10  has  been  so  to  plan  reorganizations  as  to 
effect  a  reduction  rather  than  an  increase  of  the  net  capitaliza- 
tion. Especially  is  this  true  of  the  old  floating  debt,  which  is 
funded  by  the  reorganization,  is  included  in  the  computation. 
The  temptation  to  issue  excessive  amounts  of  junior  securities 
no  longer  exerts  a  malign  influence.  The  state  railroad  com- 
missions have  not  countenanced  the  unbridled  issue  of  junior 
securities,  stockholders  show  a  more  intelligent  discrimination 
between  nominal  and  real  value,  and  the  era  of  railway  promo- 
tion, with  its  exaggerated  promises  of  future  earnings,  has 
passed.  The  railroad  business  is  fighting  now  to  retain  what 
earnings  it  has ;  it  no  longer  cuts  its  financial  pattern  according 
to  the  fabulous  earnings  of  an  unattainable  future  prosperity. 


CHAPTER   XXVII 

THE   REORGANIZATION   OF   INDUSTRIALS 

Difference  Between  Industrial  and  Railroad  Reorganiza- 
tion.— The  methods  that  have  been  pursued  in  reorganizing 
industrial  corporations  have  been  analogous  to  those  employed 
for  railroads,  but  the  general  form  and  detailed  structure  of 
the  plans  differ  markedly.  This  is  because  of  the  essential 
differences  between  railroads  and  manufacturing  or  mer- 
cantile enterprises.  In  their  social  status  as  public  service  cor- 
porations and  from  the  similarity  of  their  operation  in 
furnishing  a  service  and  not  a  commodity,  railroads  are  all 
alike. 

I.  Fluctuation  of  Earnings. — Industrial  enterprises  have 
little  in  common  among  themselves  except  the  absence  of  those 
very  characteristics  possessed  by  public  service  enterprises. 
One  class  operates  under  the  conditions  of  a  protected  monop- 
oly, the  other  under  conditions  of  free  competition.  There 
are  no  real  monopolies  of  location  in  the  industrial  field,  and 
whatever  approach  to  monopoly  can  be  discovered  lies  in  the 
direction  of  control  over  patents  or  trade-marks.  Therefore 
the  earnings  of  any  single  industrial  must  be  subject  to  abrupt 
fluctuations  due  to  changes  in  the  general  purchasing  power  of 
the  community  and  to  changes  in  the  managerial  ability  ex- 
ercised by  the  men  in  control.  From  the  beginning  their 
financial  plan  must  therefore  be  based  on  the  presumption  that 
the  business  can  rely  on  itself  alone  in  protecting  its  trade 
position,  never  on  the  community.  This  fact  is  paramount  in 
formulating  any  plan  for  reorganizing  an  industrial  under- 
taking. 

330 


XXVII]        THE  REORGANIZATION  OF  INDUSTRIALS  331 

2.  Absence  of  Funded  Debt. — Most  industrial  corporations, 
because  of  the  fluctuating  character  of  the  earnings,  were 
organized  without  bonds.  For  this  reason  many  companies 
which  have  been,  on  the  whole,  unsuccessful,  have  been  able 
to  survive  successive  business  depressions  and  single  unprofita- 
ble years  without  ever  meeting  the  necessity  of  reorganization. 
So  long  as  they  met  the  direct  expenses  of  operation  and  pos- 
sibly the  preferred  stock  dividends,  they  could  run  along  the 
even  tenor  of  their  way,  however  small  their  net  earnings. 
The  fact,  therefore,  that  an  industrial  corporation  has  not  been 
reorganized  in  no  wise  argues  for  its  fundamental  success. 

Enforced  reorganization  of  railroads  has  occurred,  almost 
invariably,  only  after  the  actual  or  threatened  failure  to  meet 
bond  interest.  Had  the  railroads  been  without  bonds  few, 
if  any,  reorganizations  would  have  been  recorded.  But  such 
is  the  insecure  position  of  many  industrials,  buying  and  selling 
in  competitive  markets,  that  reorganization  has  been  neces- 
sitated by  the  mere  losses  incurred  by  their  ordinary  business 
transactions.  Thus  in  the  six  months  prior  to  the  reorganiza- 
tion of  the  old  Consolidated  Cotton  Duck  Company  into  the 
International  Cotton  Mills  Corporation,  the  former  company 
endured  a  net  manufacturing  loss  of  $244,000  which  was 
augmented  by  the  payment  of  interest  amounting  to  $575,- 
000.  Many  other  industrial  reorganizations  have  followed  in 
the  wake  of  conditions  so  unfortunate  that,  in  spite  of  the  fact 
that  bond  interest  was  absent,  the  corporation  could  not  meet 
the  expenses  incident  to  its  ordinary  business. 

3.  Position  of  Creditors. — This  suggests  that  general 
creditors  of  industrial  enterprises  are  in  a  stronger  position 
than  the  general  creditors  of  railroads.  Their  liens  are  not 
ordinarily  superseded  by  those  of  bondholders,  nor  is  the 
practice  of  permitting  the  issue  of  receivers'  certificates  to  take 
precedence  over  ordinary  general  creditors  so  often  permitted 


332  CORPORATION  FINANCE  [XXVII 

by  the  courts.  The  general  creditors  can,  therefore,  by  threaten- 
ing to  Hquidate  the  property  of  the  company,  force  the  stock- 
holders to  meet  fully  their  claims.  On  the  other  hand,  the 
internal  organization  of  an  industrial  company,  being  some- 
times the  most  valuable  part  of  the  corporation's  property, 
would  be  jeopardized  should  the  old  management  surrender  the 
corporate  assets  to  the  creditors  and  start  a  new  competing 
business  of  their  own.  The  creditors  are  thus  at  a  disadvantage 
in  dealing  with  them,  in  spite  of  the  apparent  security  of  their 
claims.  In  view  of  all  these  considerations  one  is  less  able  than 
in  the  case  of  railroads  to  form  even  tentative  generalizations. 
One  cannot  say,  for  example,  that  a  temporary  shortage  of 
money  and  a  permanent  overburdening  of  capital  charges  will 
be  found  present  as  a  condition  precedent  to  every  industrial 
reorganization  as  is  the  case  in  every  railroad  reorganization. 
Nor  can  one  find  sufficient  grounds  for  the  presumption  that 
relief  from  a  heavy  floating  debt  and  a  reduction  of  fixed 
charges  are  the  invariable  consequences  of  every  industrial 
reorganization.  The  most  that  can  be  said  is  that  ordinarily 
in  industrial  reorganizations  some  new  working  capital  is  sup- 
plied and  there  is  some  readjustment  of  the  forms  of  capitaliza- 
tion. And  while  this  readjustment  of  the  capitalization  is  likely 
to  entail  a  lessening  of  the  fixed  charges,  cases  are  by  no  means 
uncommon  in  which  a  reorganization  burdened  an  industrial 
with  new  and  increased  charges. 

4.  Possibility  of  Liquidation. — Unlike  railroads,  industrial 
enterprises  may  ordinarily  be  liquidated  if  such  a  course  seems 
expedient.  Sometimes  it  is  even  expedient  to  liquidate  a  busi- 
ness before  a  critical  condition  has  arisen,  especially  if  a  large 
part  of  its  assets  are  easily  salable.  Yet  under  the  best  con- 
ditions the  sale  of  corporate  assets  is  bound  to  show  losses  as 
compared  with  their  book  value.  If  the  enterprise  has  little 
hope  of  success  it  will  be  best  under  all  circumstances  for  those 


XXVII  ]         THE  REORGANIZATION  OF  INDUSTRIALS  333 

interested  to  recognize  the  fact  and  sell  the  property  for  what 
it  will  bring,  even  though  the  creditors  will  suffer  considerable 
loss  and  the  stockholders  entire  loss.  Experience  drawn  from 
various  enterprises  that  were  reorganized  several  times  in  suc- 
cession shows  that,  severe  as  would  have  been  the  losses  at  the 
time  of  the  first  reorganization,  they  were  small  compared  to 
those  endured  by  the  men  who  continued  to  add  new  money 
at  the  time  of  each  successive  failure. 

5,  Significance  of  the  Personal  Element. — The  most  con- 
spicuous difference,  however,  between  railroad  and  industrial 
reorganization  is  the  greater  significance  of  the  personal  ele- 
ment in  the  latter.  It  was  asserted  in  the  opening  paragraphs 
of  the  second  chapter  of  this  volume  that  human  or  psychologi- 
cal considerations  were  the  most  important  and  often  the 
determining  motives  in  all  reorganizations.  This  assertion  is 
conspicuously  true  in  the  case  of  industrial  reorganizations, 
whether  one  considers  the  reorganization  of  a  little  village 
factory  or  that  of  a  great  enterprise  like  the  Westinghouse 
Electric  and  Manufacturing  Company,  with  branches  and 
affiliations  all  over  the  world.  The  popularity  of  the  chief 
executive  officers  is  able  often  to  carry  such  weight  with 
bankers  that  a  plan  of  reorganization  is  accepted  which  other- 
wise would  have  been  thrown  aside;  the  dislike  of  business 
associates  toward  some  man  has  often  been  the  direct  cause 
leading  to  a  crisis  In  the  affairs  of  a  corporation  with  which  he 
was  connected  and  the  ultimate  acceptance  of  a  plan  of  re- 
organization the  main  purpose  of  which  was  to  eliminate  him 
from  the  management.  Jealousy  always  plays  an  important 
role.  Personal  likes  and  dislikes  determine  the  lines  of  cleavage 
among  the  various  interests  directly  affected  and  the  strength 
of  these  lines  of  cleavage  determines  the  plan  of  reorganiza- 
tion ultimately  imposed  on  all  concerned.  These  personal 
motives  are  seldom  apparent  on  the  surface,  yet  they  exert  a 


334  CORPORATION  FINANCE  [XXVIl 

subtle    influence   at    every    turn    in    all    industrial    reorgani- 
zations. 

Chief  Object  of  an  Industrial  Reorganization. — If  it  is 
decided  that  the  business  shall  be  reorganized  it  is  necessary 
to  discover  the  causes  of  failure.  As  already  pointed  out  in 
another  connection,  corporations  do  not  ordinarily  fail  because 
of  lack  of  working  capital,  but  rather  the  appearance  of  a  lack 
of  working  capital  is  an  outward  sign  of  fundamental  dif- 
ficulties. The  real  cause  of  industrial  failure  is  quite  as  little  apt 
to  be  a  difficulty  of  securing  credit  due  to  sudden  tightening  of 
the  money  market  as  in  the  case  of  railroad  failures,  although, 
if  there  is  any  opportunity,  this  cause  will  be  alleged.  As  in 
the  case  of  railroads,  the  real  reason  underlying  the  difficulty 
in  securing  further  bank  loans  is  not  the  obstinacy  of  the  banks 
but  the  impoverished  credit  of  the  company.  Quite  probably 
the  corporation  paid  interest  on  debt  and  even  dividends  out  of 
capital  during  the  period  prior  to  the  acknowledged  failure, 
although  this  interpretation  of  their  action  will  be  avoided  by 
the  directors.  Yet  the  ^act  will  remain,  whether  cause  or 
effect,  that  the  failed  corporation  is  in  straits  and  requires  more 
ready  money.  So  that,  as  in  the  case  of  railroad  reorganiza- 
tions, the  chief  ends  of  industrial  reorganizations  are  neces- 
sarily the  removal  of  the  underlying  cause  of  the  failure  and  the 
collection  of  new  money.  But  in  the  case  of  railroad  reorgani- 
zations, the  underlying  cause  is  usually  connected  with  an 
excessive  fixed  charge.  This  is  not  always  true  with  indus- 
trials, because  many  industrials  in  financial  straits  have  been 
altogether  without  bonded  debt.  Consequently,  although  the 
purpose  of  collecting  new  money  is  invariably  present  in  every 
industrial  reorganization,  the  rest  of  the  reorganization  does 
not  always  turn  about  the  problem  of  reducing  the  fixed 
charges.  It  may  happen — in  fact  it  often  does  happen — that 
the  need  for  new  money  is  so  urgent  that  a  new  fixed  charge  is 


XXVII  ]  HE  REORGANIZATION  OF  INDUSTRIALS  335 

added  because  the  sale  of  first  mortgage  bonds  is  the  only  mean<i 
available  to  obtain  new  money.  The  stability  of  the  future  is 
sacrificed  to  meet  the  necessities  of  the  present. 

Obtaining  Money  for  Reorganization. — At  the  time  of  the 
reorganization  free  money  is  often  obtained  by  the  receivers 
indirectly  by  ceasing  the  payment  of  interest  on  debt  or  the 
principal  of  maturing  obligations.  If  this  is  not  ample,  the 
receivers  may  be  permitted  by  the  court  to  issue  receivers' 
certificates,  although  the  reasons  for  the  issue  of  these  certifi- 
cates must  be  more  urgent  and  the  amounts  less  liberal  than 
in  the  case  of  railroads  and  public  utilities.  The  indiscriminate 
and  reckless  issue  of  receivers'  certificates,  which  the  federal 
courts  have  tolerated  in  recent  cases  of  railroad  receivership,  is 
absent  in  the  case  of  industrials.  The  courts  have  assumed  that 
the  necessities  of  the  public  do  not  require  the  continuation  of 
the  business  at  a  loss  to  the  creditors  and  stockholders. 
Whether  or  not  receivers'  certificates  are  issued,  the  problem 
for  the  reorganization  managers  is  the  same — to  obtain  enough 
new  money  to  meet  the  outstanding  debts  of  the  old  corporation 
and  to  supply  the  reorganized  corporation  with  adequate  work- 
ing capital. 

Selling  Securities  to  Outside  Banks. — The  simplest  method 
of  obtaining  new  money  is  to  sell  securities  to  outside  banks. 
In  this  way  the  stockholders  are  not  required  to  act  individu- 
ally nor  to  make  conscious  sacrifices,  except  perhaps  the  mere 
consent  to  a  new  bond  issue. 

If  no  mortgage  or  other  form  of  funded  debt  exists, 
bankers  will  frequently  consent  to  buy  a  small  issue  of  first 
mortgage  bonds  of  the  reorganized  company  on  the  assumption 
that  the  assets  are  at  least  sufficient  to  cover  the  debt.  In  such 
cases,  it  is  common  for  bankers  to  insist  that  the  new  company 
maintain  large  fluid  assets  further  to  strengthen  the  bonds. 


33^  CORPORATION  FINANCE  [XXVII 

And  even  when  the  new  company  is  able  to  show  assets  far 
in  excess  of  the  new  debt,  the  difficulty  lies  in  finding  invest- 
ment bankers  who  will  consent  to  buy  any  securities  whatever 
of  an  enterprise  known  to  be  on  the  verge  of  bankruptcy. 
Without  regard  to  the  fundamental  security  of  the  bonds, 
bankers  of  high  standing  are  unwilling  to  permit  their  names 
to  be  connected  with  enterprises  likely  to  become  notorious 
through  repeated  failures. 

As  a  rule,  therefore,  bankers  are  willing  to  advance  money 
to  relieve  a  threatened  or  actual  failure,  only  in  those  cases  in 
which  the  embarrassment  is  to  be  traced  to  causes  easily  dis- 
covered and  easily  remedied.  Future  success  then  turns  upon 
the  question  of  management.  To  safeguard  themselves  against 
bad  management  and  even  a  repetition  of  failure,  and  to  give 
the  corporation  the  advantage  of  their  specialized  knowledge, 
the  bankers  who  do  advance  money  under  such  circumstances 
always  require  that  at  least  one  of  their  associates  be  elected 
to  the  board  of  directors.  It  is  quite  usual  for  them  to  go  even 
further  and  assume  the  actual  financial  administration  of  the 
new  corporation.  Furthermore,  to  secure  this  co-operation  and 
to  make  the  bankers'  interest  in  the  new  company  worth  while 
the  corporation  may  pay  the  bankers'  commission  partially  or 
wholly  in  common  stock.  Very  frequently  the  greatest  benefit 
resulting  from  the  reorganization  is  the  new  moral  support  of 
the  bankers  and  the  general  confidence  which  this  support 
engenders.  Their  money  is  soon  spent,  but  their  co-operation 
remains.  As  a  result  of  these  considerations  it  may  be  said,  in 
summary,  that  those  reorganizations  in  which  the  new  money 
has  been  supplied  by  independent  bankers  have  followed, 
almost  invariably,  failures  of  the  least  serious  sort.  This  is 
particularly  true  of  failures  attributable  to  some  temporary 
emergency  not  likely  to  occur  again — such  as  the  sudden 
tightening  of  the  money  market  or  the  immediate  need  for 
new  equipment. 


XXVII 1        THE  REORGANIZATION  OF  INDUSTRIALS  337 

Assessment  of  Security-Holders. — When  the  necessary 
new  money  cannot  be  obtained  by  such  simple  means  as  the  sale 
of  treasury  assets  or  the  quiet  sale  of  new  bonds  to  outside 
bankers,  it  must  be  subscribed  by  the  stockholders.  This 
method,  although  perfectly  fair,  because  the  stockholders  are 
the  real  owners  of  the  business  and  should  bear  the  burden,  is 
found  difficult  to  apply  in  practice  because  of  the  reluctance  of 
stockholders  to  face  the  result  of  failure  squarely.  In  defer- 
ence to  this  feeling  and  to  remove  the  taint  of  assessment,  it 
is  common  to  give  to  the  stockholders  a  new  contingent  charge 
security  in  return  for  their  money  contributions.  This  usually 
takes  the  form  of  a  preferred  stock  and  is  not  likely  to  be  as 
carefully  safeguarded  as  the  bonds  which  are  sold  to  bankers. 
Yet  no  bonds  are  placed  ahead  of  it,  for  otherwise  the  stock- 
holders would  not  subscribe.  If  there  is  reason  to  suppose  that 
the  stockholders  will  not  voluntarily  submit  to  what  is  virtu- 
ally an  assessment,  the  directors  may  find  it  necessary  to  throw 
the  corporation  into  the  hands  of  receivers  and  submit  to  a 
judicial  sale  of  its  assets.  In  no  other  way  can  the  non-con- 
tributing stockholder  be  eliminated.  But,  as  in  the  case  of 
railroads,  this  extreme  method  of  coercion  is  both  expensive  in 
money  and  destructive  to  the  credit  and  trade  position  of  the 
corporation.  It  is  resorted  to  only  in  extreme  cases  when  the 
recalcitrant  stockholder  cannot  be  reached  by  all  the  arts  of 
persuasion.  The  second  Westinghouse  reorganization  of  1908 
is  notable  in  that  no  sale  of  the  corporation  occurred  and  the 
stockholders  contributed  a  large  amount  of  money,  for  which 
common  stock  only  was  given  them.  However  forceful  this 
exception  appears,  the  fact  remains  that  threatened  loss  of 
their  entire  investment  alone  is  ordinarily  able  to  wrest  new 
money  from  stockholders. 

An  unusual  but  efficient  and  direct  plan  is  followed  by  the 
Massachusetts  textile  mills  when  they  find  their  credit  impaired. 
The  stockholders  first  authorize  the  reduction  of  the  capital 


338  CORPORATION  FINANCE  [XXVII 

Stock  by  a  certain  proportion,  possibly  50  per  cent.  This  in- 
volves the  cutting  of  each  stockholder's  interest  in  half.  They 
then  authorize  the  sale  of  the  stock  surrendered  at  par  to 
either  the  old  stockholders  or  outside  bankers.  The  final  result 
of  these  two  steps  is  a  substantial  increase  in  the  available 
money,  without  any  increase  whatever  in  either  the  amount  of 
stock  outstanding  or  the  direct  liabilities.  This  method  has 
been  applied  in  other  reorganizations  outside  of  New  England, 
but  in  a  less  drastic  form.  Its  advantages  lie  in  its  simplicity 
and  the  slight  dislocation  of  the  corporation's  business  which 
is  likely  to  occur.  It  is  merely  a  matter  of  sacrifice  on  the 
part  of  the  stockholders  to  enable  the  corporation  to  strengthen 
its  general  credit. 

Money  can  be  obtained  from  bondholders  only  in  case  the 
funded  debt  is  considerable  and  the  apparent  equity  remaining 
to  the  stockholders  comparatively  small.  If  there  are  reasons 
to  believe  that  the  assets  of  the  corporation  can  be  liquidated  or 
can  be  sold  at  judicial  sale  for  an  amount  sufficient  to  cover 
the  bonded  debt,  no  pressure  can  be  brought  against  the  bond- 
holders. They  would  prefer  to  "allow  the  law  to  take  its 
course"  rather  than  to  contribute  to  the  relief  of  the  company. 
It  is  therefore  only  in  cases  of  extreme  embarrassment  that  help 
may  be  expected  from  the  bondholders;  and  it  follows  from 
this  that  the  worse  the  failure  proves  to  be,  the  more  the 
bondholders  will  be  concerned  in  the  reorganization.  Yet  even 
when  no  equity  remains  to  the  stockholders  and  the  corporate 
assets  are  less  than  the  debt,  it  is  usual  to  allow  the  stockholders 
to  come  into  the  reorganization  on  the  payment  of  a  heavy 
assessment  in  order  to  maintain  the  continuity  of  the  business 
organization.  Care  must  be  taken,  however,  to  ascertain  either 
that  this  stockholders'  assessment  will  be  paid,  or  that  the 
failure  of  the  stockholders  to  respond  will  not  jeopardize  the 
success  of  the  reorganization.  When  the  stock  of  the  old 
company  is  selling  at  a  few  cents  a  share  in  the  market,  it  is 


XXVII  ]        THE  REORGANIZATION  OF  INDUSTRIALS  339 

evident  that  the  stockholders  will  make  little  sacrifice  to  save 
it,  and  the  bondholders  would  probably  do  well  to  reorganize 
the  company  alone  without  the  tentative  help  of  the  stock- 
holders. If  more  than  one  issue  of  bonds  existed  in  the 
capitalization  of  the  old  company,  some  difficulty  arises  in 
apportioning  the  relative  amounts  which  the  different  bond- 
holders should  contribute.  Generally  speaking,  the  underlying 
senior  bondholders  can  be  relied  upon  but  little,  and  most  of 
the  new  money  must  be  collected  from  the  junior  bondholders. 
Yet  if  the  junior  bonds  are  of  little  value,  their  holders  will 
relinquish  all  interest  in  the  reorganized  company  rather  than 
pay  any  considerable  assessment.  In  such  a  case  the  senior 
bondholders  have  no  other  alternative  than  to  furnish  the 
money  necessary  with  perhaps  slight  help  from  the  junior  bond- 
holders. Such  a  reorganization  plan  would  follow  only  the 
most  serious  failure. 

Assessment  of  Outside  Creditors. — Cases  in  which  an 
assessment  or  money  contribution  is  required  of  the  outside 
creditors  are  very  rare  and  are  likely  to  occur  only  as  a  result 
of  unusual  circumstances.  Either  the  outside  debt  is  unsecured 
and  there  exist  mortgage  bonds  which  have  a  prior  lien  on 
essential  assets — in  which  case  the  creditors  are  in  a  position 
analogous  to  the  junior  bondholders — or  else  the  creditors  are 
impelled  to  assist  the  corporation  from  reasons  of  permanent 
self-interest.  In  the  former  case  they  submit  to  the  payment  of 
a  small  assessment  to  enable  the  corporation  to  continue  in 
business,  knowing  that  if  the  assets  were  liquidated  their  claims 
could  not  be  paid  in  full.  As  in  many  other  instances  a  money 
assessment  is  wrung  from  a  class  of  security-holders  as  the 
price  paid  for  a  chance  to  recover  apparent  losses. 

In  the  latter  case  the  reasons  of  permanent  self-interest  are 
those  of  continued  profit  through  enabling  the  corporation  to 
continue  in  business.     Many  of  the  unsecured  creditors  have 


340  CORPORATION  FINANCE  [XXVII 

claims  representing  open  accounts  and  merchandise  notes, 
arising  through  the  ordinary  business  relations  with  the  failed 
corporation.  These  merchandise  transactions  have  been  a 
source  of  profit  in  the  past,  and  the  merchandise  creditors  have 
every  reason  to  believe  they  will  continue  to  be  so  in  the  future 
— provided  the  business  can  be  rehabilitated.  The  creditors 
are  therefore  willing  to  buy  its  long-time  notes — or  even  its 
stock — provided  there  is  reasonable  assurance  that  the  new 
company  will  purchase  goods  of  them  in  the  future. 

Changes  in  Capitalization — No  Uniformity. — If  we  turn 
from  those  aspects  of  the  financial  plan  of  industrial  reorgani- 
zations having  to  do  with  the  sources  of  new  money  to  those 
dealing  with  the  permanent  changes  in  the  capitalization,  there 
is  discernible  even  less  ground  for  possible  generalizations.  It 
was  already  pointed  out  that  the  principle  laid  down  in  rail- 
road reorganization,  that  the  fixed  charges  were  invariably 
reduced  with  the  possible  increase  in  total  capitalization,  does 
not  hold  true  in  the  reorganization  of  industrial  enterprises. 
Not  only  may  the  total  capitalization  be  increased  by  the  re- 
organization, but  that  portion  having  fixed  charges  is  as  likely 
to  be  increased  as  not.  In  fact,  one  of  the  commonest  means 
of  relieving  a  company  in  financial  difficulties  has  been  to  fund 
the  current  debt  into  first  mortgage  bonds,  though  the  com- 
pany may  have  had  no  funded  debt  before.  The  specific  form 
of  the  reorganization  plan  is  therefore  determined  by  two 
independent  sets  of  circumstances,  the  financial  structure  before 
the  embarrassment  and  the  seriousness  of  the  embarrassment. 
As  the  financial  structure  of  all  our  great  railway  systems  is 
essentially  the  same,  an  important  distinction  among  railroad 
reorganization  plans  could  be  based  on  the  seriousness  of  the 
failure  alone ;  but  owing  to  the  fact  that  this  unity  of  financial 
structure  does  not  prevail  among  industrials  no  such  simplicity 
of  classification  is  possible. 


XXVII]        THE  REORGANIZATION  OF  INDUSTRIALS  341 

When  Object  Is  to  Escape  Unpaid  Dividend  Charges 

Those  reorganizations  consummated  primarily  to  relieve  the 
corporation  of  an  accumulation  of  unpaid  preferred  dividend 
charges,  usually  avow  a  balance  of  advantages  to  both  pre- 
ferred and  common  shareholders.  They  involve,  ordinarily, 
some  capital  readjustment  which  brings  the  common  stock 
nearer  to  the  payment  of  dividends  and  turn  almost  always 
upon  some  modification  of  the  preferred  stock  contract.  The 
holders  of  this  class  of  stock,  knowing  that  their  claim  to 
unpaid  dividends  is  indirect,  and  that  they  are  powerless  to 
enforce  the  payment  no  matter  how  large  the  earnings  of  the 
corporation  may  be,  are  usually  willing  to  release  their  claim 
to  dividends  in  return  for  some  concession  from  the  corpora- 
tion. In  rare  instances  only  it  amounts  to  the  payment  of  the 
accumulated  dividend  in  money.  It  may  take  the  form  of : 
( I )  the  issue  of  a  new  higher  dividend-paying  preferred  stock 
in  exchange  for  the  old  cumulative  preferred  stock  with  its 
arrears  of  unpaid  dividends;  (2)  a  funding  of  the  preferred 
stock  dividend  accumulations  into  new  securities ;  ( 3 )  the  fund- 
ing of  the  old  contingent-charge  preferred  stock,  with  its  ac- 
cumulated dividends,  into  new  bonds  bearing  interest  charges 
lower  than  the  dividend  rate  on  the  old  preferred  stock.  All 
these  methods  have  been  used  with  success.  Invariably,  the 
management,  controlled  by  the  common  shareholders,  re- 
presents that  the  plan  to  be  adopted  is  of  mutual  benefit  to  all 
classes  of  security-holders.  In  some  cases  it  is,  in  other  cases 
it  is  not.  For  one  observes  easily  that  in  each  of  the  means 
adopted  the  direct  charges  of  the  corporation  are  increased. 
And  the  advisability  of  the  whole  readjustment  depends  on 
whether  or  not  this  disadvantage  is  more  than  balanced  by 
greater  advantages. 

When  Object  Is  to  Decrease  Floating  Debt. — Much  more 
important    are    those    industrial    reorganizations    which    are 


342  CORPORATION  FINANCE  [XXVII 

planned  primarily,  of  ten  entirely,  to  relieve  the  corporation  of  an 
overpowering  burden  of  floating  debt.  Until  the  recent  practice 
of  railroads  in  issuing  short-term  notes  had  brought  about  its 
evil  consequences,  failures  and  reorganizations  resulting  from 
an  embarrassing  burden  of  floating  debt  were  confined  to  the 
history  of  industrial  corporations.  The  long-established 
practice  of  the  vast  majority  of  industrials  of  carrying  at  least 
a  part  of  their  quick  assets  by  means  of  short-time  loans  from 
the  banks,  places  the  industrial  in  a  peculiarly  vulnerable  posi- 
tion when  the  lending  banks  refuse  to  continue  or  extend  the 
corporation's  notes. 

Peculiar  difficulty  is  found  in  differentiating  reorganiza- 
tions of  this  class  from  all  others,  because  the  management  of 
every  embarrassed  industrial  alleges  at  the  time  that  the  dif- 
ficulty is  due  entirely  to  the  obstinacy  of  the  banks,  or  their 
inability  to  extend  credit  further.  Were  these  diagnoses  made 
by  the  embarrassed  corporations  themselves  to  be  taken  at  their 
face  value,  every  industrial  failure  and  reorganization  would 
be  of  this  class.  But  the  diagnosis  of  the  corporation  is  seldom 
correct.  Other  more  fundamental  causes  usually  underlie  the 
withdrawal  of  credit.  In  some  few  instances,  to  be  sure,  an 
unmanageable  floating  debt  is  the  fundamental  cause,  just  as 
the  corporation's  officials  declare,  but  its  existence  is  to  be 
attributed  much  more  probably  to  the  stupidity  of  the  manage- 
ment in  allowing  the  debt  to  pile  up  than  to  the  obstinacy  or 
limitations  of  the  banks. 

The  crux  of  all  reorganizations  of  this  class  is,  obviously, 
the  means  to  be  taken  to  pay  or  to  fund  the  floating  debt. 
A  receivership  is  nearly  always  resorted  to  in  order  to  prevent 
the  possibility  of  attachments,  so  that  there  is  ample  time  to 
consider  the  means  available.  If  there  is  no  mortgage  on  the 
property  of  the  company,  the  easiest  plan  to  execute — and  for 
that  reason  the  one  most  frequently  followed — is  to  sell  an 
issue  of  first  mortgage  bonds  to  bankers,  and  with  the  proceeds 


XXVII 1        THE  REORGANIZATION  OF  INDUSTRIALS  343 

pay  off  the  holders  of  the  floating  debt.  If  the  management 
and  the  stockholders  are  unwilling  to  do  this,  or  if  there  already 
exists  a  mortgage  on  the  property,  then  a  reorganization  has 
to  be  carried  out  which  involves  a  direct  as  well  as  an  indirect 
sacrifice  on  the  part  of  the  old  security-holders.  In  other 
words,  the  old  stock  or  bondholders,  or  both,  must  suffer  an 
assessment  and  take  new  junior  securities  in  return;  and  with 
the  proceeds  of  the  assessment  a  part  or  all  of  the  floating  debt 
can  be  paid  off.  This  is  merely  the  use  of  the  general  principles 
already  discussed  under  railroad  reorganization  expedients, 
except  that  no  particular  effort  is  made  to  decrease  the  fixed 
charges. 

One  feature  of  industrial  reorganization  plans  of  this 
class — intended  to  do  away  with  an  unmanageable  floating 
debt — deserves  at  least  passing  notice.  It  is  the  provision  in 
the  vast  majority  of  such  plans  to  force  the  holders  of  the 
debt  to  take  securities  as  a  part  of  their  claims.  The  old 
noteholders  and  merchandise  creditors  are  asked  to  accept  some 
percentage,  perhaps  50  per  cent,  of  their  claims  in  cash  and 
the  rest  in  long-term  notes — usually  of  various  maturities. 
The  creditors  ordinarily  accept  this  compromise.  They  re- 
cognize that  by  forcing  the  corporation  into  bankruptcy  they 
can  undoubtedly  secure  the  collection  of  at  least  a  part  of  their 
claims,  but  the  remaining  part  will  be  forever  lost.  Whereas 
if  they  show  a  willingness  to  co-operate  with  the  stockholders 
to  the  extent  of  funding  a  part  of  their  debt  into  i-,  2-,  or  even 
5-year  notes  they  give  the  stockholders  an  opportunity  to  work 
out  the  rehabilitation  of  the  company,  and  with  its  rehabilita- 
tion the  creditors  can  ultimately  secure  the  full  payment  of  their 
obligations.  At  least,  this  is  the  kind  of  argument  advanced 
to  them  and  to  which  they  are  usually  amenable. 

When  Object  Is  to  Lessen  Fixed  Charges. — Those  in- 
dustrial   reorganizations    which    are    consummated    for    the 


344  CORPORATION  FINANCE  [XXVII 

avowed  purpose  of  lessening  the  fixed  charges,  are  invariably 
the  result  of  failure.  If  the  failure  is  not  serious,  or  if  the 
corporation  has  merely  shown  a  continued  low  earning  power 
while  its  affairs  have  never  reached  a  serious  crisis,  it  is  some- 
times possible  to  induce  bondholders  to  consent  to  a  lessening 
of  the  principal  and  interest  of  their  bonds.  But  ordinarily 
bondholders  will  not  endure  even  a  nominal  sacrifice  without 
coercion,  and  the  various  steps  of  default,  receivership,  and 
foreclosure  sale  have  to  be  followed  in  order  to  compel  the 
bondholders  to  submit  to  a  lessening  of  their  charges.  When 
such  steps  are  necessary  the  industrial  reorganization  differs, 
so  far  as  the  plan  is  concerned,  but  little  from  the  typical  rail- 
road reorganizations  discussed  in  the  previous  chapters.  There 
is,  perhaps,  a  little  greater  tendency  to  deal  harshly  with  bond- 
holders in  requiring  them  to  exchange  bonds  for  stock,  but  the 
general  principle  that  industrial  enterprises  ought  not  to  have 
bonds  in  their  financial  plan  is  ample  excuse  for  taking 
advantage  of  the  opportunity  of  a  reorganization  to  eliminate 
entirely  the  funded  debt.  At  all  events  the  principle  holds  true, 
as  in  railroad  reorganizations,  that  the  corporation  must  be 
relieved  from  the  burden  of  fixed  charges  in  order  that  it  may 
strengthen  its  own  internal  organization  and  its  mercantile 
credit.  Permanent  strength  can  be  obtained  only  through  a 
period  of  rest  and  reconstruction.  And  this  principle,  in  spite 
of  the  varying  circumstances  of  its  application,  must  be  the 
paramount  motive  in  every  industrial  reorganization  where 
failure  is  to  be  attributed  primarily  to  a  burden  of  fixed  charges. 
In  these  reorganizations  involving  a  decrease  or  the  entire 
cancellation  of  the  funded  debt,  the  problem  always  turns  on 
the  kind  of  security  the  bondholders  are  willing  to  accept.  If 
the  security  offered  is  not  satisfactory  to  them  they  are  in  a 
position  to  force  the  liquidation  of  the  assets  of  the  corporation. 
This  result  would  give  the  bondholders  the  little  that  there  was 
and  the  stockholders  nothing.    Even  at  the  time  of  involuntary 


XXVII  ]        THE  REORGANIZATION  OF  INDUSTRIALS  345 

reorganizations,  therefore,  some  advantages  must  be  attached 
to  the  new  stocks  offered  in  exchange  for  the  old  bonds — or  the 
stockholders  must  otherwise  strengthen  the  corporation's  credit 
— else  the  bondholders  will  not  accept  them.  These  advantages 
are,  on  the  one  hand,  a  heavy  cash  payment  by  the  old  stock- 
holders into  the  treasury  of  the  new  company  in  exchange  for 
a  second  preferred  or  common  stock,  and,  on  the  other  hand, 
the  acceptance  by  the  old  bondholders  of  a  new  first  preferred 
stock  or  an  income  bond.  The  rate  on  the  contingent  charge 
security  offered  the  old  bondholders  is  ordinarily  a  little  higher 
than  that  carried  by  the  old  bonds.  A' higher  contingent  rate 
is  exchanged  for  a  lower  fixed  rate.  Furthermore  the  new  pre- 
ferred stock?  are  seldom  immediately  cumulative  in  their 
dividend  demands;  yet,  in  order  to  protect  the  new  preferred 
stockholders  from  the  avarice  of  the  common  stockholders  who 
maintain  control,  the  preferred  stock  dividends  are  often  made 
cumulative  after  a  period  sufficiently  long  to  enable  the  re- 
organized company  to  have  fully  regained  its  credit. 

Advantages  of  Voluntary  Reorganization. — Whatsoever 
may  be  the  primary  purpose  of  the  reorganization,  whether  to 
benefit  one  class  of  the  security-holders  or  the  general  credit 
of  the  corporation  through  a  lessening  of  the  fixed  charges,  a 
voluntary  reorganization  is  to  be  preferred  to  a  receivership 
and  foreclosure  sale.  Even  more  than  with  railroads  and 
other  public  service  corporations,  the  notoriety  of  failure, 
bankruptcy,  and  litigation  impedes  the  normal  business  of  an 
industrial  corporation.  Its  general  credit,  including  its  bank- 
ing facilities,  is  hurt;  especially  is  its  general  trade  standing 
imperiled.  The  internal  operating  force  and  the  selling  force 
become  disorganized,  careful  as  the  receiver  may  be.  Custom- 
ers avoid  business  dealings  with  an  insolvent  concern.  Fully 
conscious  of  all  these  considerations,  those  in  control  of  the 
business  will  seek  to  effect  a   "friendly"   reorganization,   in 


346  CORPORATION  FINANCE  [XXVII 

which  the  impending  crisis  is  reHeved  by  voluntary  purchase 
of  junior  securities  by  one  or  more  classes  of  security-holders. 
This  is  not  possible  if,  as  in  the  case  of  most  large  railroads, 
there  are  a  host  of  creditors  and  conflicting  interests,  but  such 
a  solution  is  unquestionably  possible  at  the  time  of  a  crisis  in 
an  industrial  or  even  small  public  service  enterprise,  if  the 
various  security-holders  and  creditors  are  on  friendly  terms  and 
not  too  widely  scattered.  Friction  and  sometimes  almost  in- 
surmountable differences  of  opinion  can  be  overcome  if  the 
affairs  of  the  company  happen  to  rest  in  the  hands  of  a  few 
keen-sighted  men  of  conciliatory  dispositions. 

In  the  effort  to  bring  about  a  "friendly"  reorganization  of 
an  industrial  corporation,  a  committee  of  the  management 
usually  sends  to  the  various  interests  a  plain  statement  of  the 
actual  facts.  Perhaps  the  floating  debt  is  too  large  and  should 
be  funded  by  voluntary  action  on  the  part  of  the  stockholders, 
or  perhaps  the  company  is  too  heavily  capitalized  and  a 
voluntary  cutting  down  of  the  stock  issues  is  necessary.  What- 
ever the  conditions,  they  are  carefully  explained  to  the  security- 
holders and  the  remedy  is  pointed  out,  which  invariably  in- 
volves some  direct  or  indirect  sacrifice  on  their  part.  If  a 
sufficient  number  agree  to  the  plan  it  is  declared  operative  and 
the  managers  proceed  to  put  it  into  execution.  There  will  be 
always  some  security-holders  who  will  refuse  to  agree  to  the 
sacrifice.  These  will  either  be  bought  off  or  "carried"  by  the 
others.  In  such  a  case  there  is  no  receivership,  no  conflict  of 
opposing  interests  represented  by  numerous  committees,  no 
foreclosure  sale,  and  no  reincorporation  under  a  new  name. 


APPENDIX 

PROBLEMS 
Introductory  Note 

In  accordance  with  a  belief  that  the  best  way  to  teach  cor- 
poration finance  is  by  discussion  of  concrete  cases,  I  have  ap- 
pended here  a  group  of  problems.  They  have  been  taken  for  the 
most  part  from  actual  experience,  although  many  irrelevant 
details  have  been  omitted.  Practically  all  of  them  have  been 
used  on  examination  papers  and  for  classroom  discussion  in  the 
course  in  corporation  finance  in  the  Harvard  School  of  Business 
Administration.  Problem  80,  for  example,  constituted  one- 
third  of  a  final  examination  paper. 

The  value  of  such  a  study  as  corporation  finance  is  to  teach 
students  to  think — not  to  teach  them  facts.  These  problems, 
many  of  them  at  least,  are  difficult;  but  it  is  to  be  presumed 
that  students  qualified  to  pursue  a  subject  like  this  have  passed 
beyond  the  stage  of  learning  things  by  rote  and  welcome  a  method 
of  instruction  that  taxes  their  powers  of  analysis  and  comprehen- 
sion to  the  utmost.  In  order,  however,  to  facilitate  an  even 
distribution  of  problems  in  courses  extending  over  different 
periods  of  time  and  among  students  of  different  grades  of  matur- 
ity, an  attempt  has  been  made  to  classify  the  problems  according 
to  their  difficulty.  Those  requiring  considerable  skill  and 
maturity  are  marked  with  a  star  (*),  and  those  of  marked 
difficulty  are  distinguished  by  a  double  star  (**). 

Without  laying  down  any  rules  for  the  use  of  these  problems, 
it  may  be  remarked  that  the  writer  has  found  it  most  useful  to 
assign  problems  to  the  class  and  then  to  devote  a  considerable 
amount  of  time  to  discussing  the  several  solutions  offered.     In 

347 


348  APPENDIX 

many  cases,  especially  with  problems  covering  promotion,  expan- 
sion, and  reorganization,  there  is  no  absolutely  right  or  absolutely 
wrong  answer.  In  each  case  it  is  a  matter  of  financial  expediency. 
The  reasons  why  one  solution  of  a  problem  is  better  than  another 
should  be  carefully  presented  so  that  men  will  understand  that 
financial  practice  is  a  matter  of  judgment.  So  far  as  possible, 
the  class  should  be  conducted  as  one  might  conduct  the  meeting  of 
a  large  board  of  directors.  The  opinion  of  each  member  of  the 
class  should  be  given  consideration  and  everyone  should  be  led 
to  feel  that  the  reasons  back  of  his  judgment  are  worthy  of 
respect. 

It  is  absolutely  necessary  for  a  student  to  have  clearly  in  mind 
the  specific  end  or  purpose  of  each  problem.  He  should  be  urged 
to  separate  in  his  mind  the  essential  parts  of  the  problem  not 
merely  from  the  mere  verbiage  but  also  from  the  unimportant 
facts  and  figures.  These  essential  parts  he  should  study  carefully 
in  their  relations  with  each  other.  Thus  if  the  problem  concerns 
itself  with  quick  assets  and  these  alone,  a  student  should  set  down 
first  all  the  information  about  quick  assets  and  discard  entirely 
from  his  consideration  every  other  fact  and  every  other  possible 
deduction  from  irrelevant  facts.  He  should  then  examine  care- 
fully the  data  concerning  quick  assets  and  make  such  deductions 
as  the  purpose  of  the  problem  involves. 

A  considerable  number  of  the  problems,  especially  those 
toward  the  end  of  the  collection,  permit  of  several  answers.  The 
student  should  discuss  his  own  solution,  indicating  the  grounds  of 
preference  over  other  possible  solutions.  He  should  give  reasons 
for  his  grounds  of  preference  and  show  their  bearing  on  matters  of 
financial  policy.  Thus  in  the  preparation  of  the  financial  plan 
of  a  public  utility,  the  necessary  capital  may,  in  a  particular 
case,  be  secured  either  by  a  small  issue  of  bonds  and  a  small  issue 
of  preferred  stock  or  by  a  large  issue  of  bonds  alone.  A  student 
who  constructs  his  financial  plan  according  to  one  or  the  other  of 
these  alternatives  should  state  explicitly  the  reasons  for  his 


PROBLEMS  349 

choice,  and,  if  possible,  the  fundamental  principles  behind  these 
reasons. 

So  far  as  possible,  moreover,  the  public  significance  of  this 
subject  should  be  emphasized.  It  should  be  borne  in  mind  that 
corporation  finance  is  one  aspect  of  a  great  body  of  economic 
questions  connected  with  our  modern  industrial  life,  and  that  no 
solution  of  financial  problems  is  permanently  sound  which  is  not 
at  the  same  time  justifiable  and  wise  from  the  point  of  view  of 
public  welfare.  Sound  investment  subserves  a  social  purpose  in 
so  far  as  it  conserves  accumulated  capital  for  productive  and 
socially  justifiable  enterprises  and  directs  it  away  from  useless 
highly  speculative  and  socially  iniquitous  projects. 

I  cannot  refrain  from  one  very  commonplace  comment  regard- 
ing the  case  method  of  study — of  which  the  use  of  concrete  prob- 
lems represents  one  form.  This  general  educational  theory  is 
based  on  the  presumption  that  a  student  has  not  mastered  a 
subject  until  he  has  been  able  to  translate  mere  factual  knowledge 
into  action — until  he  can  do  something  with  his  knowledge.  Not 
only  does  the  study  of  definite  cases  test  the  student's  grasp  on 
fundamental  principles,  but  it  also  affords  a  form  of  training 
which  should  be  the  ideal  of  all  educational  processes — it  creates 
conditions  that  force  a  student  to  isolate  relevant  evidence  from  a 
mass  of  detail  and  weigh  this  evidence  in  the  light  of  principles. 
It  creates  a  mental  and  moral  power  that  enables  a  man  to  meet 
new  situations  in  any  field,  wherever  his  life  work  may  lie. 

Chapter  I — The  Corporation  and  Its  Financial  Structure 

I.  The  following  represents  the  report  of  an  accountant  covering  the 
business  of  John  H.  Taylor,  dealer  in  meats  and  groceries  in  South  Law- 
rence, Massachusetts,  as  of  January  i,  1922.  Taylor  proposes  to  incor- 
porate his  business  and  issue  to  himself  and  his  wife  all  the  shares  of  capital 
stock  of  a  par  value  of  $100  each.  How  many  shares  will  Taylor  and  his 
wife  receive?  What  will  be  the  balance  sheet  of  the  John  H.  Taylor  Com- 
pany after  incorporation? 


350  APPENDIX 

Condition  of  Business  of  John  H.  Taylor  as  of  January 

I,  1922 

Merchandise $4,700 

Store  Fixtures 2,800 

Wagons,  Horses,  etc 1,800 

Accounts  Payable 1,100 

Accounts  Receivable 1,600 

2.  A  corporation  owes  nothing.  It  has  fixed  property  to  the  value  of 
$680,000,  cash  to  the  amount  of  $4,000,  and  bills  receivable  to  the  amount 
of  $116,000.  It  has  no  surplus  account,  but  it  has  two  classes  of  stock, 
common  and  preferred,  equal  in  amount.  The  par  value  of  the  preferred 
is  $100  and  that  of  the  common  $25.  How  many  shares  of  stock  has  the 
corporation? 

*3.  Thomas  Edwards,  born  in  Fort  Edward,  New  York  State,  in  1843, 
was  apprenticed  to  a  retail  furniture  dealer  in  Syracuse  in  1857.  Finally 
in  1874,  having  saved  $3,400,  he  entered  into  partnership  with  a  man  of 
his  own  age,  for  the  purpose  of  purchasing  the  assets  of  a  retail  furniture 
business  that  had  failed  the  previous  year.  The  firm  of  Edwards  and 
Hopkins  prospered.  Originally,  Edwards  had  paid  in  $3,400  and  Brown 
$7,600 — making  $11,000  in  all.  They  had  paid  $27,000  for  the  business, 
giving  $16,000  in  notes  in  part  payment.  By  1880  the  partnership  had 
paid  the  notes.  In  1885  Hopkins  died  and  Edwards  acquired  the  former's 
interest  in  the  business  for  the  sum  of  $18,000 — an  amount  which  he 
borrowed  from  local  banks  on  the  credit  of  the  business.  Edwards  died  in 
1922,  leaving  two  unmarried  daughters  both  over  fifty  years  of  age.  The 
balance  sheet  of  the  business  at  the  time  of  Edwards'  death  was  as  follows 
(in  even  000) : 

Assets  Liabilities 

Inventory $  65,000       Current  Accounts $  7,600 

Unmatured  Loans 6,000      Proprietor's  Interest 96,400 

Accounts 24,000 

Fixtures  and  Wagons 3. 500 

Overdue  Notes 5.500 

$104,000  5104,000 


There  were  two  clerks  who  understood  the  business,  but  who  had  only 
),ooo  between  them  with  which  to  purchase  the  business. 


PROBLEMS 


351 


The  executor  of  the  estate  proposed  to  liquidate  the  business  and  di- 
vide the  proceeds  between  the  two  heirs.  A  friend  suggested  that  a  cor- 
poration might  be  formed  to  continue  the  business,  under  the  management 
of  the  two  clerks,  and  in  this  way  the  two  maiden  ladies  would  realize,  in 
the  end,  more  from  their  father's  estate. 

Point  out  the  advantages  or  disadvantages  of  the  friend's  plan,  and, 
were  it  accepted,  how  could  the  old  proprietary  business  be  transformed 
into  a  corporation  so  that  the  interests  of  the  two  ladies  would  be  protected 
and  at  the  same  time  the  permanent  interest  of  the  two  clerks  be  assured? 

Chapter  II — Common  Stock 


4.  The  following  represents  the  balance  sheet  of  the  Stoneboro  Manu- 
factiuing  Company. 


Assets 


Liabilities 


Plant $1,568,000      Capital  Stock  (par  $100) 


Patents  and  Trade- 
Marks  (at  cost,  pro- 
perly written  down) . .  768,560 

Raw  Material 165,000 

Goods  in  Process 278,000 

Finished  Goods 73.650 

Notes  Receivable 190,000 

Accounts  Receivable 76,724 

Cash 22,863 

Deficit 7,318 

$3,150,115 


Common $1 ,000,000 


Preferred 

Mortgage  Bonds . . 

Debentures 

Notes  Payable 

Accounts  Payable . 


600,000 
800,000 
200,000 
365,000 
185,115 


5,150,115 


(a)  What  is  the  capitalization  of  this  company? 

(b)  What  is  its  capital? 

(c)  What  is  its  capital  stock? 

(d)  What  is  the  net  worth  of  each  share  of  common  stock,  provided 
the  preferred  stock  could  be  liquidated  at  par? 

(e)  The  owners  of  this  business  decided  to  exchange  the  common  stock 
into  stock  of  no  par  value.  What  changes  should  be  made  in  the  entries 
on  this  balance  sheet  to  make  it  conform  to  the  new  condition? 

In  discussing  this  problem  it  is  important  to  observe  the  differences  in 
the  uses  of  the  two  words,  "  capitalization"  and"  capital,"  in  economic 
theory,  business,  and  corporation  finance. 


352 


APPENDIX 


5.  The  following  is  the  statement  of  the  Merchants  Trust  Company- 
member  of  federal  reserve  system.  What  is  the  book  value  or  net  worth 
of  its  stock? 

Statement  of  Conditions 
October  i,  1920 
Assets  Liabilities 

United  States  Bonds .  $306,704.90  Capital $200,000.00 

Bonds  and  Securities  905,033.20  Surplus 200,000.00 

Loans  and  Discounts.  2,627,073.33  Undivided  Profits.  .  .             62,690.32 

Bank  Building,  Vault,  Deposits 4,209,158.89 

and  Fixtures 90,300.00 

Cash   on    Hand    and 

Due  from  Banks.  .  742,737.78 

$4,671,849.21  $4,671,849.21 


Should  you  say  that  bank  stock  would  ordinarily  sell  for  more  or  less 
than  its  book  value?  Give  a  series  of  questions  that  you  might  ask  con- 
cerning a  bank  to  ascertain  whether  the  market  value  of  its  shares  was 
greater  or  less  than  the  book  value.  Would  you  expect  to  find  the  differ- 
ence between  the  book  value  and  the  market  value  of  the  stock  of  a  small 
country  bank  greater  or  less  than  the  difference  for  the  stock  of  a  large 
New  York  bank? 

Explain  your  answer. 

*  6.  (This  problem  requires  some  knowledge  of  accounting.) 

The  Stamford  Coal  Corporation  has  total  assets  of  $785,000,  and  total 
notes,  bonds,  and  bills  payable  of  $316,000.  It  has  accumulated  a  sur- 
plus of  $1 27,000.  It  has  outstanding  $300,000  of  preferred  stock,  par  value 
$100  a  share.  The  directors  decide  that  the  outstanding  common  stock, 
of  a  par  value  of  $10  a  share,  shall  be  exchanged  share  for  share  for  common 
stock  of  no  par  value. 

An  accountant  once  said  that  the  problem  of  bringing  no-par-value 
stock  onto  the  balance  sheet  of  a  corporation  is  an  important  and  dif- 
ficult problem,  on  the  ground  that  accountants  have  no  uniform  method 
of  treating  no-par- value  stock.  He  stated  further  that  no-par-value  stock 
can  be  brought  onto  the  balance  sheet  in  at  least  three  different  ways. 

Prepare  three  different  balance  sheets  of  the  Staniford  Coal  Corpora 
tion,  after  the  above  described  change,  showing  three  different  ways  of 
indicating  the  no-par- value  stock. 


PROBLEMS  353 

Chapter  in — Bonds 

7.  The  statutes  controlling  the  issue  of  bonds  by  Massachusetts  local 
public  utilities  require  that  bonds  shall  not  exceed  stock,  and  that  the 
total  securities  to  be  issued  by  the  utility  shall  not  exceed  the  cost  of  the 
property. 

The  Berkshire  (Massachusetts)  County  Electric  Company  was  built 
at  a  total  cost  of  $316,000.  What  was  the  maximum  amount  of  bonds 
that  could  be  issued? 

8.  The  Constuners  Electric  Light  Corporation  had  outstanding  in  19 13 
$765,000,  5%  mortgage  bonds.  The  company  was  allowed  under  the 
original  mortgage  to  issue  additional  bonds  "for  improvements,  extensions, 
etc.,  at  85%  of  actual  cost,  and  then  only  when  net  earnings  applicable  to 
interest  were  equivalent  to  i>2  times  the  interest  charges  on  all  bonds 
outstanding  including  those  to  be  issued."  Construction  costs  amounted 
in  the  preceding  year  to  $43,564.  The  gross  earnings  were  $312,000  and 
the  total  operating  expenses  $221,000. 

What  is  the  amount  of  new  bonds  that  can  be  issued? 

9.  A  corporation  has  outstanding  $1,568,000  first  mortgage  6%  bonds. 
These  were  originally  issued  under  an  indenture  that  provided  for  the  issue 
of  additional  bonds  to  pay  for  80%  of  the  cost  of  new  construction,  but 
only  if  the  net  earnings,  after  depreciation,  for  the  preceding  year  were  at 
least  twice  the  interest  charges  on  the  bonds  a'  ady  issued  and  those  to 
be  issued. 

On  January  i,  1921,  the  following  income  and  expense  statement  was 
presented  to  the  board  of  directors  covering  the  business  of  the  preceding 
year. 

Gross  Receipts $608,731 

Cost  of  Operation  Including  Labor,  Materials,  and  Small 

Repairs $285,760 

Maintenance   of    Plant,    Structures,  and    Distributing 

System 98,623 

Taxes 24,201 

Depreciation 27,000 

Losses  by  Fire  and  Debts  Charged  Off 3.765 

Improvements  and  Extensions 68,300 

Interest  Charges  on  Bonds 78,400 

Interest  on  Floating  Debt 5,760 

Balance  on  Hand 1 6,922 

$608,731     $608,731 

23 


354  APPENDIX 

How  many  new  bonds,  if  any,  can  the  board  of  directors  authorize? 

*io.  A  corporation  with  the  following  balance  sheet  and  income  account 
proposes  to  issue  some  additional  first  and  refunding  mortgage  bonds. 
It  is  provided  in  the  indenture  that  additional  bonds  may  be  issued  pro- 
vided the  total  bonded  debt  is  not  greater  than  the  capital  stock;  provided 
the  net  earnings  are  at  least  twice  the  total  interest  charges,  including 
that  of  the  bonds  to  be  issued;  and  provided,  finally,  the  par  value  of  the 
new  bonds  be  not  greater  than  the  capital  expenditures.  But  it  was  pro- 
vided in  another  connection  that  at  least  io%  of  the  total  machinery  ac- 
counts and  4%  of  the  plant  accounts  must  be  expended  or  set  aside  out  of 
earnings  before  betterments,  replacements,  or  improvements  can  be  pro- 
perly charged  to  capital. 

How  many  new  bonds  can  the  corporation  issue? 

Balance  Sheet 

(Somewhat  Simplified) 
Assets  Liabilities 

Buildings    and    Struc-                            Common  Stock $4,000,000 

tures $1,875,000      Preferred  Stock  7% 3,000,000 

Machinery 4,658,000      First  Mortgage  6%  Bonds  1,500,000 

Inventories 6,783,000      Second      Mortgage     5% 

Cash 285,000          Bonds i  ,000,000 

First      and      Refunding 

Mortgage  5  %  Bonds. .  .  i  ,360,000 
Notes,     Bills,    and     Ac- 
counts Payable 1,568,000 

Surplus 1,173,000 


$13,601,000  $13,601,000 

Gross   Income   for   the   Year   After   Deducting    Raw 

Materials,  Labor,  Salaries $3,023,000 

Repairs  and  Maintenance $178,000 

Taxes,  Partly  Estimated 216,000 

Floating  Debt  Interest,  Discounts 96,000 

Bonds  Interest 208,000 

Insurance 21,000 

Losses  on  Inventory  and  Bad  Debts 16,000  735,000 

Net  Income  Before  Depreciation  or  Dividends $2,288,000 

Depreciation 103,000 

Dividends,  7%  on  Both  Classes 490,000 

Betterments 784,000 

Surplus 91 1,000 


PROBLEMS  355 

1 1.  The  treasurer  of  the  Old  Ladies'  Home  of  Georgetown^  Inc.,  died  in 

1919.  fiis  successor,  Warren  Taylor,  Esq.,  was  appointed  in  the  spring  of 

1920.  Mr.  Taylor  desired  to  obtain  expert  opinion  concerning  the  invest- 
ments held  by  the  trustees  of  the  Old  Ladies*  Home.  Accordingly,  he 
prepared  a  report  of  these  investments  with  reference  to: 

1.  The  character  of  security  (class  of  bond,  preferred  or  common 

stock). 

2.  The  type  of  enterprise. 

3.  Short,  medium,  or  long  term. 

Below  is  given  the  list  of  securities.  Prepare  such  a  report  as  Mr. 
Taylor  desired. 

Atchison,  Topeka  and  Santa  Fe  Railway  General  Mortgage  4's  Gold,  1995 

Great  Falls  Power  Company  First  Mortgage  5's,  1940 

Bethlehem  Steel  Company  First  and  Refunding  Mortgage  5's,  1942 

United  States  Realty  and  Improvement  Debenture  5's,  1924 

Illinois  Central  Litchfield  Division  First  Mortgage  3's,  1951 

Erie  Railroad  Prior  Lien  4's,  1996 

American  Telephone  and  Telegraph  Company  Collateral  Trust  4's,  1929 

Chicago  Gas  Light  and  Coke  Company  First  Mortgage  Guaranteed 

5's,  1937 
General  Electric  Company  Debenture  3J^'s,  1942 
Illinois  Central  Railroad  and  Chicago,  St.  Louis  and  New  Orleans, 

Joint,  First  and  Refunding  5's,  1963 
Baltimore  and  Ohio,  Southwestern  Division  3K's,  1925 
Adams  Express  Company  Collateral  Trust  4's,  1948 
St.  Louis  and  San  Francisco  Income  Mortgage  6's,  i960 
Kanawha  and  Michigan  First  Mortgage  Guaranteed  4's,  1990 
Manhattan  Railway  Second  Mortgage  4's,  2013 
Kansas  City  Terminal  First  Mortgage  4's,  i960 
Tennessee  Copper  Company  Convertible  Debenture  6's,  1925 
New  York  and  Erie  Railroad  Fifth  Mortgage  4's,  1928 
Henderson  Bridge  Company  First  Mortgage  6's,  193 1 
Louisville  and  Nashville  Secured  Gold  Notes  7's,  1930 

12.  On  December  31,  191 7,  the  San  Antonio  and  Aransas  Pass  First 
Mortgage  4%  bonds  were  outstanding  to  the  amount  of  $17,544,000. 
These  bonds  were  guaranteed  principal  and  interest  by  the  Southern 
Pacific  Company,  which  held  $404,000  in  its  treasury.  For  the  year  191 7 
the  following  is  the  abbreviated  operating  account  of  the  San  Antonio 
and  Aransas  Pass  Railroad. 


356  APPENDIX 

Gross  Earnings $4,X78,I9I 

Operating  Expenses 3.517,594     ' 

Non-Operating  Income 170,910 

Taxes 195.103 

Rentals 27,283 

Interest  on  Equipment  Obligations 14.500 

Floating  Debt  Interest 232,978 

Miscellaneous  Expenses 1.707 

To  what  extent  was  the  railroad  a  source  of  direct  profit  or  a 
direct  burden  to  the  Southern  Pacific  Company?  Does  this  indicate 
that  the  road  was  necessarily  a  profitable  or  unprofitable  subsidiary? 
Explain. 

13.  The  Northern  Maine  and  Penobscot  Railroad  acquires  a  collection 
of  miscellaneous  equipment  at  a  total  cost  of  $2,000,000.  It  pays  10%  of 
cost  price  at  the  time  the  equipment  is  delivered.  The  remainder  is  ob- 
tained through  the  issue  of  equipment  trust  certificates,  bearing  5%  inter- 
est, and  maturing  in  equal  semiannual  instalments  for  a  period  of  10 
years.  The  certificates  were  sold  to  bankers  at  97^2  less  ]/2  point  com- 
mission. The  legal  and  other  expenses  attendant  upon  the  issue  amounted 
to  $3,800.  These  expenses,  together  with  the  discount,  were  amortized 
evenly  over  the  life  of  the  certificates. 

What  was  the  total  charge,  because  of  this  equipment  trust,  during  the 
eighth  year  after  issue? 

*i4.  The  Wilkesboro  and  Southern  Railroad  has  outstanding  $3,000,000 
first  mortgage  5%  bonds,  $2,000,000  of  preferred  stock  having  non-cumula- 
tive 4%  dividends ,  and  $2,000,000  common  stock.  Its  first  mortgage  bonds 
sell  for  103,  its  preferred  stock  for  $66  a  share,  and  its  common  stock  for 
$48  a  share.  The  earnings  warrant  a  2%  dividend  on  the  common  stock; 
the  market  price  has  risen  from  $13  a  share  to  the  present  level  during  the 
last  1 5  months. 

One  million  dollars  is  required  for  expansion.  Bankers  offer  to  buy  at 
90%,  $1,500,000,  20-year  second  mortgage  5%  bonds,  or  at  par  $1,500,000, 
6%  debenture  bonds  convertible  into  common  stock  on  the  basis  of  80. 
The  directors  chose  the  latter  alternative.  In  3  years  the  common  stock 
has  risen  to  $92  a  share  and  all  the  convertible  bonds  have  been  converted. 
Meanwhile  the  dividend  has  been  increased  to  7%. 

What  is  now  the  greater  cost  of  capital  of  the  second  alternative  over 
the  first?  Had  the  directors  been  able  to  forecast  the  movement  of  the 
common  stock  at  the  time  the  bonds  were  issued,  should  they  have  issued 


PROBLEMS  357 

the  second  mortgage  bonds  rather  than  the  convertible  debentures?     Ex- 
plain your  answer. 

15.  A  certain  issue  of  4%  bonds  of  the  Union  Pacific  Railroad  was  con- 
vertible in  the  common  stock  at  a  ratio  of  175%.  At  one  time  the  common 
stock  was  selling  at  148  and  paying  10%.  The  bonds  were  selling  at  97. 
An  investor  placed  $9,700  in  the  bonds,  with  the  intention  of  converting 
them  into  the  stock  when  it  was  profitable  so  to  do.  Exactly  2  years  later 
the  stock,  meanwhile  paying  the  same  rate  of  dividends,  sold  at  $175  a 
share.    The  investor  converted. 

How  much  more  profitable  would  it  have  been  for  him  to  have  bought 
the  stock  2  years  before?    Do  not  consider  interest  on  interest. 

16.  A  certain  issue  of  the  4%  bonds  of  the  Erie  Railroad  is  convertible 
into  the  common  stock  at  60.    The  bonds  are  acquired  at  47. 

What  is  an  equivalent,  i.e.,  corresponding  price  for  the  common  stock? 

17.  The  4^%  bonds  of  the  Baltimore  and  Ohio  Railroad  are  converti- 
ble into  the  common  stock  at  1 10%.  Ten  thousand  dollars  par  value  of  the 
bonds  are  purchased  at  82^8,  the  speculator  borrowing  the  money  at  $% 
interest,  interest  payments  being  made  semiannually.  The  bonds  are 
held  exactly  3  years ,  at  which  time  they  are  converted.  The  common  stock 
received  is  immediately  sold  at  $103  a  share. 

Compute  the  speculator's  entire  profit  or  loss. 

18.  A  corporation  known  as  the  Gas  Securities  Corporation  issued  on 
March  10,  1913,  some  6%  i-year  notes  at  98.  Between  March  10,  and 
May  10,  the  notes  could  be  converted  into  $1,000  preferred  stock  and  $300 
par  value  of  common  stock.  Thereafter,  on  the  tenth  of  each  month,  the 
amount  of  common  stock  to  be  received  on  conversion  was  reduced  by  $10, 
par  value,  so  that  during  the  last  month  of  the  year  the  notes  ran,  only 
$200  of  the  common  stock  was  given.  On  August  18,  1913,  the  preferred 
stock  had  a  value  of  I78  a  share  and  the  common  stock  a  value  of  $8  a 
share. 

Did  it  pay  the  purchaser  of  a  note  to  convert? 

Chapter  IV—  Preferred  Stocks 

19.  The  Turner-Jameson  Company,  Lynn,  Massachusetts,  manufac- 
turers of  ladies'  fine  shoes,  decide  to  solicit  capital  from  outside  sources. 
Their  balance  sheet  at  the  time  stands  as  follows  (the  numbers  represent 
even  000  and  have  been  somewhat  simplified) : 


358 


APPENDIX 


Assets 

Upper  Leather $161,000 

Sole  Leather  and  Findings  1 13,000 

Goods  in  Process 78,000 

Finished  Goods  and  Goods 

Billed  on  Memorandum  93,000 

Machinery  Owned 31,000 

Cash 17,000 


$493,000 


Liabilities 

Common  Stock $200,000 

Essex     County     National 

Bank  of  Lynn 50,000 

Miscellaneous  Notes  and 

Acceptances,  discounted 

at  Boston  banks 87,000 

Accounts  Payable 103,000 

Surplus 53,000 

$493,000 


The  business  has  been  profitable,  but  the  demand  for  ladies'  fine  shoes 
has  dropped  off  of  late.  In  consequence,  the  company  has  an  abnormally 
large  stock  of  leather  and  an  abnormally  large  volume  of  outstanding  notes 
and  accounts.  The  bankers  advise  the  sale  of  an  amount  of  preferred  stock 
equivalent  to  the  common  stock,  and  the  use  of  the  proceeds  to  pay  off 
some  of  the  bank  and  merchandise  creditors.  The  treasurer  of  the  com- 
pany, pursuant  to  this  advice,  sells  preferred  stock  to  bankers  at  par  less 
10%  discount. 

Prepare  the  balance  sheet  after  the  whole  transaction  has  been  com- 
pleted. 

20.  The  Thomaston  Water  Company  was  organized  in  1894.  It  then 
had  a  capitalization  of  $300,000  common  stock.  In  the  course  of  time 
extensions  were  built  and  $200,000  of  6  per  cent  cumulative  preferred 
stock  was  issued  and  sold  in  1907  to  pay  off  the  floating  debt  incurred. 
Beginning,  however,  in  1908,  the  company  found  itself  forced  to  make  still 
greater  and  more  expensive  improvements,  and  at  the  same  time  its  usual 
facilities  for  borrowing  were  closed.  Accordingly,  the  company  paid  only 
the  preferred  dividends  due  in  1908  and  thereafter  turned  all  earnings  into 
new  construction.  In  1915  the  company  had  finished  its  extensive  im- 
provements, was  earning  net  over  $50,000  a  year,  and  was  in  a  position  to 
resume  preferred  stock  dividends.  The  directors  offered  to  give  the 
preferred  stockholders  new  5%,  20-year  first  mortgage  bonds  in  lieu  of  their 
accumulated  (unpaid  dividends),  adjusted  as  of  January  i,  1916 — the 
bonds  to  be  taken  at  88. 

How  large  an  issue  was  necessary? 

*  21.  James  Edgerly  owned  about  four-fifths  of  the  common  stock  of 
the  Edgerly  Manufacturing  Company  engaged  in  the  manufacture  of 
brass,  bronze,  and  copper  specialties.      The  company  had  been  a  success 


PROBLEMS 


359 


for  over  20  years,  during  which  time  Edgerly,  himself,  had  been  the  ex- 
ecutive manager  for  18  years,  or  since  the  death  of  his  father.  On 
March  10,  192 1,  Edgerly  committed  suicide.  A  committee  of  the  pre- 
ferred stockholders,  after  careful  study  of  the  situation,  decided  to  liqui- 
date the  business.  They  reported  the  balance  sheet,  as  of  March  i,  1921, 
as: 


Assets 

Real  Estate,  Land,  Cost 

$100,000 

Buildings 

216,000 

Machinery 

634,000 

Small  Tools  and  Miscel- 

laneous Equipment. . . 

65,000 

Raw  Material,  Cost .... 

492,000 

Goods  in  Process 

116,000 

Finished  Goods,  Unsold, 

or  Else  Held  for  Can- 

celed Orders,  Cost 

221,000 

Accounts  Receivable .  .  . 

79,000 

Notes  Receivable 

1 1 1 ,000 

Cash 

22,000 

Liabilities 
Capital  Stock: 

Common $500,004 

Preferred,    7%,    Non- 
cumulative  750,000 

First    Mortgage   Bonds, 

5%,  Callable  at  I02>^  300,000 

Notes  Payable 216,000 

Accounts  Payable 97,000 

Surplus 193,000 


$2,056,000 


$2,056,000 


The  land  on  which  the  factory  building  stands  is  sold  for  about  28% 
above  the  cost,  but  the  building  itself  will  have  to  be  torn  down  and  will 
yield  nothing  to  the  shareholders.  The  machinery  has  for  years  been 
carried  on  the  books  at  cost,  without  depreciation.  It  is  sold  for  junk  at  a 
price  of  about  $40,000.  About  $10,000  is  realized  from  the  sale  of  the 
small  tools. 

The  crisis  in  the  affairs  of  the  company  was  brought  about  by  the  sud- 
den decline  in  the  price  of  raw  material.  About  46%  of  cost  is  realized  on 
the  raw  material  account.  The  goods  in  process  are  finished  at  an  expense 
of  $15,000,  after  which  they  are  sold  for  about  $33,000.  The  finished 
goods,  being  mostly  unmarketable  specialties,  realize  only  about  20%  of 
the  cost.  A  loss  of  12%  is  taken  on  the  open  accounts.  The  notes  receiv- 
able are  all  indorsed  by  a  commission  house,  which  acquires  them  imme- 
diately at  a  discount  of  2%.  In  the  liquidation  of  the  company  the  pre- 
ferred stock  has  priority  over  the  common. 

What  will  the  holder  of  one  preferred  share  receive  as  a  liquidating 
dividend? 


36o  APPENDIX 

**22.   (This  problem  involves  some  knowledge  of  accounting.? 

The  City  Manufacturing  Corporation  had  outstanding,  January  i, 
1919,  $3,000,000  common  stock  and  $3,000,000,  7%  cumulative  preferred 
stock  upon  which  there  had  accumulated  63%  of  unpaid  dividends.  But 
during  1919  the  corporation,  by  reason  of  war  conditions,  had  accumulated 
a  profit  and  loss  surplus,  after  payment  of  and  reserves  for  taxes,  of 
^3)763,000.  The  corporation  had  no  bonded  debt.  Of  this  surplus  all  but 
$27,300,  carried  as  cash,  had  been  invested  in  extensions  of  plant  or  in 
increased  net  assets.  To  reduce  the  current  assets  would  disturb  the 
pleasant  relations  with  creditors,  and  the  directors  were  opposed  to  in- 
creasing the  current  borrowings  at  the  banks.  They  wished  to  declare  a 
3%  dividend  on  the  common  stock,  which  would  involve  the  payment  of  the 
accumulated  dividends  on  the  preferred.  To  accomplish  this  end  the  pre- 
ferred stockholders  were  offered — and  the  latter  accepted — a  cash  divi- 
dend of  23%  and  the  remainder  in  6%  first  mortgage  bonds  taken  at  par. 
To  carry  out  the  plan  the  corporation  issued  $3,000,000,  lo-y ear  first  mort- 
gage 6%  bonds;  all  not  taken  by  the  preferred  shareholders  were  sold  to 
bankers  at  90. 

Prepare  a  balance  sheet  of  the  City  Manufacturing  Corporation  as  of 
January  i,  19 19,  creating  for  the  purpose  reasonable  entries  for  items  not 
specifically  mentioned  in  the  problem.  Then,  using  the  same  balance  sheet 
as  a  basis,  show  the  balance  sheet  of  the  corporation  after  the  dividends  on 
the  two  classes  of  stocks  have  been  paid. 

Chapter  V — The  Promoter  and  Banker 

23.  Amos  Jenkins  brought  to  Edward  Riley  and  Company,  investment 
bankers,  the  proposition  of  financing  a  new  shoe  factory,  of  which  Jenkins 
was  to  act  as  general  manager  having  executive  charge  of  the  new  business. 
Edward  Riley  and  Company  obtained  a  report  on  Jenkins  from  a  mercan- 
tile agency,  as  a  preliminary  step.  The  report  stated  that  Jenkins  was  a 
very  able  shoe  manufacturer,  particularly  skilful  in  the  purchase  of  raw 
materials.  He  had  been  accused  by  one  employer  of  securing  secret  rebates 
from  a  large  leather  house  and  had  immediately  withdrawn  without  at- 
tempting to  disprove  the  accusation.  He  had  been  refused  by  the  First 
National  Bank  a  line  of  credit  in  case  he  should  build  a  shoe  factory  of  his 
own.  He  had  been  sued  by  his  father-in-law  for  converting  to  his  own  use 
— for  margins  on  stock  exchange  transactions — 12  bonds  owned  by  his 
sister-in-law.  The  case  had  been  settled  out  of  court.  He  had  a  "poor 
pay"  reputation  for  meeting  his  small  living  bills.  Edward  Riley  and  Com- 
pany were  convinced  that  the  project  was  sound  economically. 


PROBLEMS  361 

How  could  they  safeguard  themselves  against  such  a  man  as  the  mer- 
cantile agency  described? 

24.  Alonzo  Emerson  and  Company,  a  small  investment  banking  house 
of  Dover,  New  Hampshire,  arranged  with  Edward  Sparrow,  a  promoter, 
to  promote  jointly  the  Dover  Shoe  Company.  Sparrow  was  to  start  the 
business  and  sell  at  least  $50,000  of  preferred  stock  with  a  bonus  of  100% 
of  common  stock.  The  Emerson  firm  was  to  sell  $200,000  preferred  stock 
with  the  same  bonus.  Each  party  was  to  receive  a  commission  of  10%  on 
all  the  preferred  stock  sold,  to  be  paid  in  common  stock.  Peter  Andrews 
and  James  Tompkins  Smith,  prominent  citizens  of  Dover,  the  former  the 
president  of  the  leading  bank  and  the  latter  the  state  Senator  for  Rocking- 
ham County,  were  each  to  receive  $25,000  in  common  stock.  They,  in 
consideration  of  this,  were  to  speak  well  of  and  to  recommend  the  new 
enterprise  to  prospective  investors.  The  balance,  if  any,  of  common  stock 
was  to  be  divided  between  Alonzo  Emerson  and  Company  and  Sparrow 
in  the  ratio  of  three  shares  to  the  former  and  one  share  to  the  latter.  The 
promotion  was  an  immediate  success  and  the  Emerson  firm  sold  their  pro- 
portion of  $200,000  prepared  stock  in  a  week.  Sparrow  then  sold  his  allot- 
ment of  $50,000  of  preferred,  giving  only  50%  bonus  with  the  first  half 
and  no  bonus  with  the  last  half.  A  half-million  dollars,  par  value,  of  com- 
mon stock  was  issued. 

How  much  went  to  Alonzo  Emerson  and  Company,  and  how  much  to 
Sparrow? 

25.  James  Ellis  and  Company,  established  investment  bankers  of  Phila- 
delphia, wish  to  compute  their  profit  or  loss  in  handling  $1,000,000  par 
value  of  the  first  mortgage  5%  bonds  of  the  Kenyon  County  Electric 
Company.    The  following  facts  are  available: 

Before  purchasing,  the  buying  department  reported  the  following 
expenses : 

Lawyers'  Fees .......  $1,600 

Accountants'  Fees 900 

Engineers'  Fees 2,700 

Traveling  and  Other  Expenses 1,180 

Clerk  Hire  and  Other  General  Expenses  to  be  Allocated 

to  this  Purchase 518 

The  bonds  were  purchased  at  88.  They  were  sold  by  the  selling  depart- 
ment to  the  public  at  93.  The  salesmen  of  the  house  devoted  themselves 
exclusively  to  the  issue  for  one  week,  put  about  half  their  time  upon  it  for 
2  weeks,  at  the  end  of  which  time  the  issue  was  entirely  sold. 


362  APPENDIX 

The  sales  manager  received  a  salary  of  |io,ooo  a  year. 

Each  salesman  received  a  commission  of  i>^  points  on  every  bond  sold 
and  an  extra  bonus  of  |i,ooo  to  be  divided  evenly  among  them  in  case  a 
new  issue  should  be  entirely  disposed  of  within  one  month  of  its  initial 
offering.  The  direct  selling  expenses  to  be  specifically  allocated  to  this 
issue  were : 

Printing $346 

Postage 186 

Clerk  Hire 72 

The  general  "overhead"  of  the  selling  department  amounted  to  $4,760 
a  year.  The  firm  set  aside  Hoi  1%  on  the  issue  to  maintain  a  market  of 
91-93  to  its  customers. 

What  was  Ellis  and  Company's  profit  or  loss? 

Chapter  VI — The  Promotion  of  New  Enterprises 

26.  A  man  by  the  name  of  Watkins  invented  a  small  device  to  be  carried 
in  the  pocket  for  sharpening  pencils.  It  could  be  manufactvu-ed  for  6  cents, 
if  ordered  in  lots  of  i  ,000.  The  inventor  wanted  a  half -interest  in  the  busi- 
ness, and  would  surrender  the  other  half  in  return  for  sufficient  capital  to 
exploit  the  patent.  There  were  no  orders  in  sight  and  the  inventor  had  no 
idea  how  to  market  his  invention.  A  private  brass  manufacturer  became 
interested  in  the  invention  and  offered  to  furnish  $5,000  capital  at  the  out- 
set, and  $10,000  more  within  a  year,  provided  the  initial  sales  indicated 
that  the  public  would  buy  the  device. 

Prepare  a  plan  for  the  promotion  of  the  "Little  Wonder  Pencil  Sharp- 
ener Company." 

27.  An  inventor  has  secured  patents  on  a  lens  consisting  of  a  series  of 
glass  prisms,  for  throwing  the  light  from  automobile  headlights  downward. 
The  headlights  of  machines  equipped  with  the  device  conform  with  certain 
state  laws.  A  promoter  is  about  to  organize  a  company,  for  the  exploita- 
tion of  the  device.  He  has  contracted  to  pay  the  inventor  $10,000  in  cash 
for  the  patent  rights  which  are  to  be  assigned  to  the  new  company  subject 
to  the  lien  of  the  purchase  money.  $5,000  is  to  be  paid  within  60  days  and 
the  balance  within  90  days. 

The  glass  for  the  lens  can  be  purchased  from  a  Pennsylvania  glass 
works  for  1 1  cents  a  pair.  The  promoter  has  leased  a  small  shop  for 
assembling  and  packing  the  device  at  $100  a  month,  which  includes  power 
and  heat.    The  labor  and  other  costs  will  be  26  cents  on  an  output  of 


PROBLEMS  363 

500  a  week  and  18  cents  or  less  on  an  output  of  over  1,000  per  week.  An 
automobile  accessory  jobbing  house  has  signed  a  contract  to  purchase  300 
pairs  of  lenses  a  week  at  85  cents  for  one  year,  provided  the  company  ex- 
pend $10,000  in  advertising  during  the  first  year.  To  equip  the  assembling 
plant  $6,000  is  required.  The  promoter,  on  behalf  of  the  new  company, 
has  agreed  with  the  accessory  jobbing  house  that  the  lenses  will  be  sold 
to  garages  for  $1.25  a  pair,  less  2%  cash,  and  that  the  retail  selling  price 
will  be  fixed  at  $2 .  The  promoter  plans  to  allow  salesmen  a  gross  commission 
of  20%  on  all  sales  to  garages.  A  revolving  fund  of  |io,ooo  is  required  to 
place  salesmen  on  the  road.  For  organization  expenses  $1,000  is  required. 
Prepare  a  financial  plan  for  the  promotion. 

28.  Frederich  Holzsmidt  came  to  this  country  as  a  penniless  German- 
Jew  immigrant.  He  became  the  ticket-seller  at  an  amusement  pavilion  at 
Coney  Island.  In  three  years  he  had  acquired  a  fifth  interest  in  the  enter- 
prise; then  followed  two  prosperous  years,  at  the  end  of  which  he  had  saved 
$3,000.  He  then  paid  his  entire  savings  for  the  other  four-fifths  interest 
and  became  the  sole  owner.  The  next  summer,  that  of  1913,  was  cold, 
rainy,  and  discouraging.  He  lost  heavily  on  his  operating  expenses.  The 
building  had  an  insurance  of  $5,000  upon  it,  and  on  the  8th  of  September 
it  caught  fire  during  the  early  morning  hours  when  no  one  was  supposed 
to  be  about.    Ultimately  Holzsmidt  collected  his  insurance  money. 

He  then  asked  Heinrich  and  Company  of  Wall  Street  to  help  him  pro- 
mote a  new  amusement  feature  to  be  known  as  "Fly-de-coop."  The 
patrons  thereof  for  the  small  sum  of  10  cents  were  given  a  ride  in  a  specially 
prepared  car  which  descended  with  increasing  velocity  a  long  inclined  plane 
and  then  shot  across  a  stream  of  water  onto  a  level  plane  beyond.  It 
would  cost  $47,500  to  build  the  feature;  the  maintenance  cost  would  be 
small  and  the  profits  large.  Holzsmidt  offered  to  contribute  his  only  capi- 
tal, $5,000,  and  wanted  Heinrich  and  Company  to  provide  $50,000,  making 
$55,000  in  all.  This  would  build  the  "feature"  and  operate  it  for  the  first 
season.  Describe,  in  detail,  all  the  information,  under  appropriate  head- 
ings, and  all  the  kinds  of  figures,  which  Heinrich  and  Company  should 
have  at  their  command  in  reaching  a  decision  whether  or  not  to  undertake 
the  promotion. 

Chapter  VII — The  Promotion  of  New  Companies  in  Established  Fields 

29.  The  board  of  trade  of  a  medium-size  city  in  western  Pennsylvania 
wished  to  attract  an  industry  to  the  city  that  employed  female  labor. 
There  were  large  steel  mills  that  gave  employment  to  men. 


364  APPENDIX 

A  silk  manufacturer,  Engalls  by  name,  entered  into  correspondence 
with  the  secretary  of  the  board  of  trade  with  a  view  of  erecting  a  silk  mill. 
The  board  of  trade  offered  to  secure  exemption  from  taxation  for  a  period 
of  6  years,  to  donate  a  factory  site  of  4  acres,  and  to  secure  subscriptions  to 
$100,000  of  the  preferred  stock  of  the  silk  mill,  provided  the  total  issue  of 
preferred  stock  did  not  exceed  one-half  the  total  cost  of  the  mill  and  the 
net  quick  assets.  The  mill,  built  and  equipped,  would  cost  $500,000.  At 
least  $200,000  of  net  quick  assets  would  be  required. 

Prepare  a  financial  plan  such  that  the  promoter  may  accept  the  sub- 
scriptions of  the  board  of  trade  and  also  receive  outside  capital  from  in- 
vestors and  banks. 

30.  A  small  shoe  factory,  located  at  Lynn,  Massachusetts,  manufactur- 
ing medium-grade  McKay  sewed  ladies'  shoes  has  been  quite  successful. 
The  present  owner,  Jeremiah  Johnson  by  name,  began  with  a  small  capital, 
only  $11,400  at  the  start  of  the  enterprise  2  years  before.  He  has  drawn 
out  of  the  business  only  $2,300  for  his  own  account  during  the  2  years. 

At  the  time  in  question  auditors  report  the  following  situation:  The 
business  is  conducted  in  an  old  wooden  building  for  the  use  of  which  the 
proprietor  pays  $100  a  month.  $2,730  has  been  invested  in  shoe  machinery 
and  $3,010  in  power  transmission  machinery  and  equipment.  The  rest  of 
the  machinery  is  under  lease  from  the  United  Shoe  Machinery  Company. 
The  business  has  leather,  findings,  goods  in  process,  and  finished  goods 
under  order,  subject  to  cancellation,  of  $52,640.  It  has  accounts  receiv- 
able of  $39,640,  on  which  it  has  borrowed  up  to  70%.  It  has  discounted 
customers'  notes  to  the  amount  of  $1 7,300.  It  has  cash  of  $2,780  and  owes 
merchandise  creditors  $31,810  and  banks  $8,500  on  its  own  paper. 

Johnson  is  an  able  manager.  One  of  the  banks,  with  whom  he  has  deal- 
ings, has  introduced  him  to  a  capitalist  who  is  willing  to  put  $50,000  into 
his  business,  provided  it  be  incorporated. 

Prepare  a  financial  plan  fair  to  both  Johnson  and  the  capitalist. 

31.  Jones,  Smith  and  Brown,  small  manufacturing  jewelers  at  Attle- 
boro,  Massachusetts,  propose  to  consolidate  their  businesses,  as  of  Jan- 
uary, 1921. 

Jones  conducts  his  business  in  the  top  story  of  a  brick  building.  He 
has  $4,700  of  material  and  manufactured  goods.  He  is  old  and  wishes  to 
retire.  He  owes  nothing,  and  has  done  business  entirely  with  a  certain 
jobbing  house  which  has  paid  him  cash  on  delivery,  so  that  he  has  no  out- 
standing accounts.  He  is  willing  to  take  stock  in  the  new  company,  pro- 
vided it  involves  no  responsibility  and  has  a  maximum  of  safety. 


PROBLEMS  365 

Smith  is  a  young  man,  ambitious  and  thought  well  of  by  the  banks 
He  does  a  mail-order  business  with  department  and  mail-order  houses 
mostly  outside  of  New  England.  Last  year  his  total  gross  sales  amounted 
to  $128,000,  of  which  $16,400  remain  as  net  profits  after  the  payment  of 
all  overhead  expenses  and  the  setting  aside  of  reasonable  reserves.  On 
January  i,  1921,  he  is  carrying  a  stock  of  materials  and  goods  amount- 
ing to  $21,380  and  has  $14,728  in  accounts  receivable.  He  owes  one 
bank  $1,000  on  $1,500  of  Liberty  bonds  borrowed  from  his  sister.  He 
has  a  cash  balance  in  another  bank  of  $2,980.  He  has  no  merchandise 
debts. 

Brown  has  an  old-established  specialty  business  for  the  manufacture 
of  gold-washed  chains.  He  wants  to  be  relieved  of  responsibility,  but  does 
not  want  to  retire.    In  brief  his  balance  sheet  is: 

Assets  Liabilities 

Plant,  a  Small  Modern  Bank  Loans $  7,200 

Brick  Building $12,000      Surplus 33, 800 

Machinery 7,000 

Material  and  Finished  Goods       8,000 

Accounts II  ,000 

Cash 3,000 


$41,000 


He  made  $27,000  the  year  before;  $20,000  he  drew  out. 
Prepare  a  plan  of  consolidation. 

32.  Three  small  tanneries  located  in  Peabody ,  Massachusetts,  each  made 
a  great  deal  of  money  during  the  Great  War.  This  was  withdrawn  by  the 
proprietors  at  the  end  of  each  year.  But  on  January  i,  192 1 ,  each  of  the 
proprietors  found  that  he  had  sustained  considerable  losses  during  the 
preceding  year.  These  losses  were  due  to  the  rapid  decrease  in  the  de- 
mand for  upper  leathers  and  to  the  very  rapid  decline  in  the  market  of 
hides  and  leather.  This  fact  of  the  severe  losses  was  not  generally  known, 
although  the  bank  from  which  one  of  the  tanners  had  increased  his  borrow- 
ings during  the  latter  part  of  the  year  had  asked  to  have  the  books  of  the 
tarmery  audited — a  request  never  before  made. 

The  following  represented  the  balance  sheets  (made  uniform  for  pur- 
poses of  comparison)  of  the  3  tanneries  as  of  January  i,  1920,  and  January 
I,  1921   (even  000): 


366  APPENDIX 

Amos  Sampson 

(Established  1890) 

Assets  Liab'dities 

1920  1921                                                              1920                   I92i 

Buildings $100,000  $100,000      Accounts   Pay- 
Machinery 65,000  60,000          able $172,000    $97,000 

Hides,  Current  Notes  Payable .       250,000       293,000 

Market 1 74,000  84,000      Surplus 94,000 

Hides  in  Proc- 
ess          29,000  3,000 

Finished  Leather        3,000  27,000 
Notes  and  Ac- 
counts    Re- 
ceivable. ..  .       110,000  92,000 

Cash 35,000  6,000 

Deficit 18,000 

$516,000  $390,000                                   $516,000    $390,000 


Edward  Dexter  and  Company 

(Established  1856) 

Assets 

Liabilities 

1920 

1921 

1920 

1921 

Buildings.  .... 

$55,000 

$55,000 

Capital  Stock. . 

$50,000 

$50,000 

Machinery .... 

72,000 

70,000 

Accounts   Pay- 

Hides,   Market 

able  

82,000 

52,000 

Value 

92,000 

2 1 ,000 

Notes  Payable . 

140,000 

120,000 

Hides  in  Proc- 

Surplus  

83,000 

18,000 

ess 

32,000 

13,000 

Finished  Leather 

26,000 

39.000 

Notes  and  Ac- 

counts     Re- 

ceivable .... 

71,000 

33.000 

Cash 

7,000 

9,000 

$355,000 

$240,000 

$355,000 

$240,000 

PROBLEMS 


367 


Tyler  and  Small 

(Established  1900) 


Assets 


Liabilities 


1920         1921 

Buildings $  200,000  $200,000 

Machinery 318,000     302,000 

Hides,    Market 

Value 178,000       98,000 

Hides  in  Proc- 
ess   71,000         4,000 

Finished  Leather  83,000     101,000 
Notes  and  Ac- 
counts      Re- 
ceivable   147,000     111,000 

Cash t6,ooo       23,000 

Deficit 77,000 


1920  1921 

Capital  Stock . .   $    500,000  $500,000 
Accounts    Pay- 


able   

Notes  Payable. 
Surplus 


165,000 

340,000 

8,000 


216,000 
200,000 


$1,013,000  $916,000 


$1,013,000  $916,000 


Sampson  has  offered  to  turn  over  his  business  with  its  going  organiza- 
tion, to  the  other  proprietors,  provided  they  assume  his  liabilities.  The 
assets,  as  of  January  i,  192 1,  for  all  the  tarmeries  have  been  marked  down 
to  the  low  current  market  values.  The  replacement  cost,  less  depreciation, 
for  the  buildings  and  machinery  accounts  of  all  3  tanneries  is  at  least  50% 
above  the  amounts  at  which  they  are  carried.  There  are  approximately 
$200,000  of  accounts  payable  of  the  3  together  that  must  be  paid  within 
the  next  3  months ;  the  rest  of  the  accounts  will  be  carried.  The  bank  loans 
will  have  to  be  reduced  by  at  least  $250,000  or  else  some  arrangement 
made  with  the  banks  for  funding  a  portion  of  the  debt.  Fully  80%  of  the 
receivables  are  represented  by  shoe  paper  which  is  likely  to  be  slow. 

Prepare  a  plan  for  the  promotion  of  a  new  corporation  to  absorb  the 
3  tanneries  and  rehabilitate  their  weakened  credit. 

Chapter  VIII — Railroads  and  Construction  Companies 

33.  James  M.  Sturgis,  country-side  physician  and  proprietor  of  the 
Keswick  Kennels — "line-bred"  English  sheep-dogs — was  an  influential 
person  of  Wilton,  New  Hampshire.  He  proposed  that  the  citizens  of  the 
town  should  build  a  new  railroad  which  should  connect  Wilton  directly 
with  Fitchburg,  Massachusetts,  a  distance  of  only  15  or  20  miles.  Sturgis 
believed  that  his  new  railroad,  the  Fitchburg  and  Wilton,  would  be  able  to 


368  APPENDIX 

make  advantageous  traffic  agreements  with  several  railroads  serving  Fitch- 
burg,  and  the  people  of  Wilton  would  be  able  to  enjoy  the  benefits  of  rail- 
road competition.  Sturgis  himself  subscribed  $25,000  to  the  $380,000 
necessary  to  build  the  line.  He  obtained  subscriptions  of  $50,000  each  from 
four  separate  "chief  citizens"  of  Wilton,  and  smaller  subscriptions  of 
varying  amounts  to  the  remainder. 

Prepare  a  financial  plan  for  the  new  Fitchburg  and  Wilton  Railroad. 

*  34.  A  certain  region  is  served  only  by  one  of  the  3  great  north-south 
railway  systems  of  the  South.  The  cotton  planters  wanted  to  introduce 
competition.  Accordingly  one  of  them  went  to  the  chairman  of  the  board 
of  directors  of  another  of  the  large  systems  known  as  the  Northern  Rail- 
way, and  suggested  that  he  build  a  branch  line  into  the  region.  For  va- 
rious reasons  it  was  impractical  for  the  Northern  Railway  to  enter  the 
competitive  field.  Nevertheless  the  chairman  of  the  Northern  Railway 
offered  to  use  his  best  efforts  to  assist  the  planters  to  build  a  line  of  their 
own  from  Geraky,  the  junction  point  on  the  Northern  Railway.  He  made 
the  following  offer: 

The  Northern  Railway  would  execute  a  traffic  agreement  with  the  new 
road,  which  will  be  called  hereafter  the  Georgia  Southern  Railway,  for  an 
interchange  of  traffic  by  which  the  Georgia  Southern  would  receive  40% 
on  all  traffic  from  stations  on  its  line,  the  latter  agreeing  to  deliver  all 
traffic  for  points  beyond  to  the  Northern  Railway  at  Geraky.  On  his 
return  the  planter  ascertained  the  following  facts:  The  branch  line  would 
be  approximately  96  miles  in  length.  It  would  reach  one  city,  Sanderson 
by  name,  of  9,000  inhabitants.  The  gross  freight  charges  on  all  the  cotton 
shipped  out  of  a  belt  extending  10  miles  on  either  side  of  the  proposed  road 
amounted  during  the  previous  year  to  $516,000.  The  freight  receipts  from 
other  shipments  amounted  to  $187,000.  Owing  to  the  feeling  against  the 
other  road  it  was  believed  that  the  Georgia  Southern  would  obtain  at  least 
%  of  all  the  outgoing  shipments  from  the  region. 

Planters  along  the  proposed  line  offered  to  donate  the  right  of  way  with- 
out charge.  Land  for  a  yard  in  Sanderson  would  cost  $1,700.  The  board 
of  trade  of  the  city,  however,  agreed  to  secure  subscriptions  to  the  new 
road  amounting  to  at  least  $80,000  in  money,  to  be  invested  in  the  securi- 
ties of  the  new  road.  Cotton  planters  along  the  line  and  merchants  in  the 
hamlets  traversed  agreed  to  provide  at  least  $136,000  under  the  same  con- 
ditions. The  chief  engineer  of  the  Northern  Railway,  who  had  been  dele- 
gated by  the  chairman  to  consult  with  the  planters,  estimated  that  the  road 
could  be  graded  for  $54,000  and  that  the  labor  in  laying  the  track,  sidings, 


PROBLEMS  369 

and  yards  would  amount  to  $116,000,  provided  the  planters  would  agree 
to  provide  sufficient  laborers  at  the  then  prevailing  wages.  He  had  been 
authorized  by  the  superintendent  of  ways  and  structures,  with  the  ap- 
proval of  the  chairman  of  the  Northern  Railway,  to  offer  to  sell  the 
planters  70-pound  relay  rails  at  $16.80  per  ton  and  to  provide  second-hand 
cross  ties  at  2  7  cents  a  piece.  The  station,  warehouse ,  and  freight  house  at 
Sanderson  would  cost  $6 2 ,000.  Stations  at  the  hamlets  would  cost  $4 1 ,000. 
Switching  facilities  at  Geraky  would  be  provided  by  the  Northern  Rail- 
way; switches,  signals,  frogs,  plates,  spikes,  etc.,  would  cost  $11,000. 
Options  on  2  second-hand  locomotives  were  obtained  for  $19,500  each ;  also 
4  second-hand  passenger  cars  at  $3,200.  The  chief  engineer  of  the  North - 
em  Railway  offered  to  put  the  cars  in  good  working  condition  for  $1,500. 
Freight  cars  and  other  equipment  would  be  rented.  Incidentals,  not  speci- 
fically mentioned,  were  estimated  to  reach  not  over  $50,000. 

Prepare  a  plan  for  the  promotion  of  the  Georgia  Southern  Railway. 

Chapter  IX — The  Promotion  of  Public  Utilities 

35.  Certain  citizens  of  the  small  town  of  Dublin  in  South  Carolina  decide 
to  organize  a  private  water  company.  The  land  about  a  small  lake  6  miles 
above  Dublin  is  acquired  at  a  cost  of  $1 1,000.  From  this  lake,  water  is  to 
be  distributed  to  the  town  by  gravity.  A  contractor  in  Charleston  offers 
to  put  in  the  water  system,  including  21  fire  hydrants,  for  $130,000.  This 
does  not  include  the  consumers'  services.  The  town  agrees  to  pay  $100  a 
year  for  each  fire  hydrant  rental.  Eight  hundred  men  agree  to  connect 
their  houses  and  purchase  water  of  the  company  at  an  average  yearly  rate 
of  $12.50.  One  factory  will  be  supplied  with  water  on  an  annual  rate  of 
$700.  Engineers  estimate  the  annual  operating  expenses,  including  repairs, 
at  $2,900  and  depreciation  at  $2,700.  The  citizens  will  subscribe  to  the 
stock  of  the  company  up  to  $60,000. 

Prepare  a  financial  plan  on  the  basis  of  which  investment  bankers  in 
Richmond  will  care  to  take  over  the  promotion  of  the  company. 

36.  A  gas  engineer  bought  a  summer  home  in  the  outskirts  of  a  small 
city  in  New  Hampshire.  He  became  interested  in  promoting  a  company  to 
supply  gas,  and  solicited  help  from  the  local  board  of  trade.  The  gas  house, 
including  a  U.  G.  I.  set,  purifiers,  etc.,  would  cost  $21,000.  The  laying  of 
the  mains  would  average  about  $1  a  foot.  It  was  planned  to  lay  only  6 
miles  of  main  to  start  with,  on  which  there  were  promises  of  618  services. 
The  gas  holders  and  miscellaneous  expenses  would  amount  to  $1 1 ,000.  It 
would  cost  for  coal  (less  by-products),  oil,  and  labor  about  85  cents  a 

24 


370  APPENDIX 

thousand  feet  of  gas,  delivered  at  the  holder.  The  customers  would  aver- 
age a  consumption  of  about  22,000  feet  of  gas,  each,  per  year.  The  price 
to  the  consumer  would  be  $1.65  per  thousand  feet.  The  depreciation 
would  be  $2 ,000  a  year.  Office  expenses  would  amount  to  $900.  A  working 
manager's  salary  would  be  $1,800  a  year,  and  the  miscellaneous  expensea 
$900.  Repairs  to  mains  and  general  maintenance  of  the  distributing 
system  would  amount  to  approximately  $1,300.  The  promoter  agreed  to 
remain  as  consulting  engineer  provided  he  be  given  a  majority  of  the  com- 
mon stock  of  the  new  company,  all  the  money  for  which  was  to  be  raised 
by  public  subscription  and  to  be  represented  by  securities,  superior  in  lien 
on  assets  and  earnings,  to  the  common  stock. 
Prepare  a  financial  plan  of  the  promotion. 

37.  Bates  and  Company  propose  one  of  2  financial  plans  to  a  promoter 
of  an  electric  power  development.  Which  is  preferable  from  the  point  of 
view  of  the  promoter?  Which  from  the  point  of  view  of  the  permanent 
welfare  of  the  enterprise? 

Total  amount  of  money  to  be  raised,  $2,000,000. 

Plan  A 

Bonds,  30-year  6% $1,600,000 

Preferred  Stock,  7% 800,000 

Common  Stock 3,000,000 

The  bankers  will  pvirchase  the  securities  in  blocks 

$1,000  in  Bonds  ) 

500  in  Preferred  Stock   >  for  $1,250 
750  in  Common  Stock   ) 

Of  the  $1,800,000  par  value  of  common  stock  remaining  the  promoter  will 
take  half  and  the  bankers  half. 

PlanB 

Bonds,  30-year  7%. .  $1,200,000  bought  by  bankers  at  90 $1,080,000 

Preferred  Stock  8% .      1,000,000  bought  by  bankers  at  70 700,000 

Common  Stock 4,000,000  of  which  $2,200,000  is  bought 

by  bankers  at  $10  a  share 220,000 

The  remainder  of  this  goes  to  the  promoter. 

*  38.  A  promoter-engineer  in  Philadelphia  heard  of  an  electric  situation 
in  West  Virginia  which  the  owner  had  offered  to  sell.  He  investigated  it 
and  found  the  following  facts: 


PROBLEMS  371 

There  was  an  old  steam  plant,  so  antiquated  and  inefficient  that, 
in  spite  of  the  fact  that  coal  was  costing  only  $1.45  a  ton  at  the 
plant,  the  generated  current  was  costing  the  company  4.62  cents  per 
k.w.h.  at  the  switchboard.  The  annual  output  was  about  780,000 
k.w.h.,  with  a  very  poor  load  factor.  The  entire  plant  would  have  to  be 
dismantled  and  a  new  plant  built  at  another  site.  This  would  cost  at  least 
$130,000,  provided  the  plant  was  constructed  so  as  to  be  efficient  for  the 
present  business  and  to  allow  for  the  available  new  business.  There  was 
one  factory  operating  on  a  9-hour  shift,  and  2  mills  both  operating  on  2 
12-hoiu"  shifts.  These  3  agreed  to  buy  their  power  of  the  company, 
provided  the  cost  would  not  exceed  2.5  cents  per  k.w.h.  and  provided  the 
company,  through  the  construction  of  a  new  plant,  would  place  itself  in 
readiness  to  furnish  adequate  and  dependable  service. 

Owing  to  the  efficiency  of  the  new  plant,  and  provided  the  3  large  cus- 
tomers were  connected,  the  total  annual  output  would  be  increased  to  ap- 
proximately 1 , 200,000  k.w.h.,  and  the  load  factor  much  improved.  Under 
these  conditions  the  switchboard  cost  could  be  reduced  to  2.2  cents,  pro- 
vided coal  remained  at  the  same  price.  This  estimate  was  based  on  the 
sale  of  360,000  k.w.h.  to  the  3  large  new  customers  at  2.5  cents  and 
an  increase  in  the  ordinary  business  of  7>^%  k.w.h.  output.  Parts  of 
the  distributing  system  would  have  to  be  immediately  rebuilt  at  a 
cost  of  $32,000.  The  financial  statement  for  the  preceding  year  was  as 
follows: 

Gross  Earnings,  less  Discounts ... $56,374 

Operating  Expenses,  Including  Salaries,  Maintenance,  and 
Repairs  (no  depreciation  reserves  had  been  set  aside  for 

at  least  5  years) 44i7i9 

Taxes 518 

Net  Earnings 11.137 

The  owner  required  $225,000  for  the  property,  for  which  price  he 
agreed  to  deliver  the  rights,  franchises,  and  physical  property  free  from 
debts. 

The  future  possibilities  of  the  city  and  its  prospective  industrial  im- 
portance was  such  that  the  promoter  remarked  to  friends  that  he  would 
have  paid  the  price  for  the  "situation"  or  the  mere  right  to  do  business, 
even  if  there  were  no  established  plant  and  business.  He  had  no  money  of 
his  own. 

Prepare  a  financial  plan  by  which  outside  investment  bankers  could 
xmdertake  to  supply  the  money  requisite  for  the  promotion. 


372  APPENDIX 

(The  comment  and  solution  of  the  following  problem  is  given  for 
illustrative  purposes.  Attention  of  the  students  should  be  drawn  es- 
pecially to  the  difference  between  the  financial  plan  of  the  Arrabassett 
Power  Company  and  that  of  a  small  industrial  such  as  that  represented 
by  the  first  three  or  four  problems  of  the  book.) 

39.  In  191 2  James  Stetson,  an  electrical  engineer,  developed  a  water 
power  on  the  Arrabassett  River  i^}4  miles  above  Galesboro,  a  city  of 
27,000  inhabitants.  He  acquired,  for  a  cash  payment  of  $316,000,  the  local 
distributing  system  of  Galesboro.  The  hydroelectric  development  alone 
cost  $617,000  and  the  transmission  line,  substation  to  Galesboro,  $46,000. 
This  total  money  cost  was  met  by  advances  from  a  syndicate  headed  by 
William  Sampson  and  Company,  under  an  agreement  by  which  the  Samp- 
son firm  obligated  themselves  to  sell  bonds  and  preferred  stock  of  the  enter- 
prise (after  it  had  been  in  operation  a  year)  so  as  to  yield  enough  money 
to  reimburse  the  syndicate  for  its  cash  advances  together  with  6%  inter- 
est and  2%  commission.  The  common  stock  was  to  be  divided  so  that 
]/i  went  to  Stetson,  )4  to  William  Sampson  and  Company,  and  ]4  to  the 
individual  underwriters.  The  Sampson  firm  were  underwriting  members 
of  their  syndicate  to  the  extent  of  a  V"  interest.  The  developments  and 
physical  connection  with  Galesboro  were  completed  November  8,  191 2. 
The  calendar  year  of  1913  showed  the  following  earning  statement  of  the 
hydroelectric  development  and  the  distributing  system  at  Galesboro. 

Gross  Earnings $339,ooo 

Operating  Expenses  (including  taxes) 162,000 

$177,000 

On  the  basis  of  this  showing  the  Galesboro  Electric  Power  Company 
was  organized  with  the  following  capitalization: 

First  Mortgage  30-year,  Sinking  Fund  5%  Bonds  (closed 

issue,  callable  at  105) $1,000,000 

6%  Preferred  Stock  ($500,000  authorized)  Issued 250,000 

Common  Stock 1,500,000 

William  Sampson  and  Company  sold  the  entire  issue  of  bonds  to  M.  U. 
Harlow  and  Company  for  88K,  who  retailed  them  to  investors  for  93>^. 
They  sold  the  issue  of  preferred  stock  to  a  group  of  6  small  banking  houses 
for  90,  who,  in  turn,  sold  the  stock  to  small  investors  for  98^^.  The  two 
issues,  therefore,  netted  the  company  $1,110,000.  The  entire  advances  of 
the  syndicate,  including  interest,  expenses,  and  commissions  amotmted  to 


PROBLEMS  373 

51,082,000.  The  balance  of  $28,000  was  returned  to  the  company's  treas- 
ury; the  common  stock  was  distributed  in  accordance  with  the  original 
syndicate  agreement. 

The  business  prospered.  In  the  early  spring  of  1916,  Stetson  acquired 
options  on  the  distributing  systems  in  6  neighboring  towns  and  cities, 
with  the  intention  of  promoting  a  large  operating  company  deriving  its 
power  from  an  enlargement  of  the  original  Arrabassett  development. 
Four  of  these  towns  lay  within  4  miles  of  the  power  station  of  Galesboro; 
the  two  cities  were  on  opposite  sides  of  a  river  26  miles  away,  in  the  op- 
posite direction  from  Galesboro. 

The  following  few  facts  are  pertinent : 

Stetson  estimates  that  improvements  at  the  power-station,  in  order  to 
furnish  ample  power,  will  require  $280,000.  A  new  transmission  line  to 
Sumpter  and  Fort  Riley  will  cost,  with  substation,  $1 18,000.  Subordinate 
lines  from  the  power-station  or  from  points  on  the  Galesboro  line  to  reach 
the  four  small  towns  will  cost  $18,000.  As  soon  as  the  connections  are 
completed  from  the  6  new  towns  and  cities  with  the  power-house  the  pre- 
vious operating  ratio  will  be  cut  12%  immediately.  This  will,  however, 
entail  an  additional  expense  of  $400  in  the  operation  of  the  power-house, 
the  costs  of  which  are  included  in  the  statement  of  the  Galesboro  Elec- 
tric Power  Company.  It  will  require  until  September  i,  1 916,  to  complete 
the  improvements  at  the  power  development  and  to  build  the  necessary 
connecting  lines. 

Stetson  further  estimates  that  if  the  expenditures  on  the  respective 
distributing  systems  for  the  6  new  towns  and  cities  are  made,  there  will  be 
an  increase  of  at  least  $42,000  in  gross  earnings  during  the  year  immediate- 
ly following  the  improvements.  Furthermore,  when  there  has  been  this 
increase  in  gross  revenue  the  composite  operating  ratio,  including  Gales- 
boro, should  show  a  further  decline  of  2%.  Without  expenditure  for  im- 
portant betterments,  Galesboro  will  show  a  rate  of  increase  of  gross  of 
about  the  average  for  the  last  3  years.  Certain  important  facts  pertain- 
ing to  these  properties  are  given  on  the  next  two  pages. 

Prepare  a  financial  plan  for  the  promotion  of  the  Arrabassett  Power 
Company  which  shall  bring  together  the  seven  properties. 

Comment  and  Solution 

General  Comment.  An  inspection  of  the  data  of  the  problem  shows  the 
following  important  pertinent  facts: 

I.  Control,  (a)  Through  the  distribution  of  the  common  stock  of  the 
Galesboro  Electric  Power  Company,  Stetson  receives  $500,000,  or  a  third, 


374 


APPENDIX 


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PROBLEMS 


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376  APPENDIX 

William  Sampson  and  Company  receives  $700,000,  The  two  interests, 
together,  therefore,  control  the  equity  of  this  property,  (b)  The  control 
of  the  new  Arrabassett  Power  Company  will  rest  with  the  same  interests 
as  the  Galesboro  Electric  Power  Company;  the  latter  will  form  the  nucleus 
of  the  new  power  company. 

2.  Past  earnings.  Considering  the  available  data,  the  aggregate  earn- 
ings of  the  7  properties  to  be  combined  are: 

Average  of  Preceding  3  Years       Preceding  Year  (1915) 

Gross  Earnings . .  $600,100  $615,800 

Net  Earnings.  . .  271,500  281,200 

3.  Money  requirements.  Since  Stetson  and  the  Sampson  firm  control 
most  of  the  common  stock  of  the  Galesboro  Electric  Power  Company, 
the  problem  will  be  to  finance  the  purchase  of  the  other  6  properties. 
This  will  require  at  a  minimum  $384,000  in  money.  This  leaves  outstand- 
ing $842,000  par  value  of  bonds,  not  considering  the  Galesboro 
securities. 

In  addition  $416,000  will  be  required  before  September  i,  1916,  for 
making  the  connections.  Likewise,  $157,000  must  be  spent  immediately 
for  improvements  in  the  6  towns.  In  case  the  promotion  should  be  planned 
so  as  to  extinguish  or  refund  the  underlying  bonds,  cash  would  have  to  be 
provided  in  addition  for  the  acquisition  of  $1,000,000  Galesboro  bonds  and 
$842,000  of  bonds  of  other  corporations. 

4.  Future  earnings.  On  the  presumption  of  the  general  accuracy  of 
the  estimates  we  may  infer  the  following  facts: 

(a)  The  operating  ratio  of  the  6  towns  (not  including  Galesboro) 

in  191 5  was  67%.  Connections  with  the  Galesboro  power-house 
will  reduce  this  to  55%.  These  connections  will  be  finished 
September  i,  191 6.  They  will  entail  an  increase  of  $400  in  the 
Galesboro  operating  expenses. 

(b)  The  first  full  year  for  which  the  estimates  are  applicable  is  the 

year  September  i,  191 6,  to  September  i,  191 7. 

(c)  There  will  be  an  increase  of  $42,000  in  the  gross  earnings  of  the 

6  towns  (not  including  Galesboro)  for  the  year  September  i, 
1916,  to  September  i,  1917. 

(d)  The  rate  of  increase  of  gross  for  Galesboro  alone  will  be  continued 

through  the  year  ending  September  i,  19 17.  This  rate  of  in- 
crease is  to  be  computed  as  follows: 


PROBLEMS  377 

Gross  for  Galesboro  Calendar  Year  1913 $339,ooo 

Gross  for  Galesboro        "  "      1914 354,800' 

Gross  for  Galesboro        "  "      1915 364,600 

Rate  of  Increase  1914  over  1913 $15,800  or  4.7% 

"     "         "        1915      "    1914 9,800  or  2.8% 

Average  Rate  of  Increase 3-7% 

During  the  calendar  year  19 16,  Galesboro  would  have  a  gross  of 
approximately  $378,100.  During  the  calendar  year  1917,  the 
gross  earnings  would  be  $392,100.  By  dead  reckoning  the 
gross  earnings  for  the  year  from  September  i,  19 16,  to  Septem- 
ber I,  191 7,  would  be  roughly  $387,400. 

(e)  The  operating  ratio  for  Galesboro  alone  would  remain  constant, 

except  that  the  operating  expenses  would  be  increased  by  $400 
due  to  the  expansion. 

(f)  The  operating  ratio  for  the  entire  properties,  all  seven,  will  be 

decreased  by  2%. 

On  the  basis  of  these  facts  we  may  proceed  to  estimate  the  gross  and 
net  earnings  of  the  entire  promotion  for  the  year  ending  September  i, 
191 7,  as  follows: 

Gross 

Galesboro $387,400 

Six  Towns 293,200 

Total $680,600 

The  estimate  of  the  operating  expenses  and  net  earnings  is  much  more 
complicated.  The  problem  is  not  clear  as  to  whether  the  reduction  of  1 2% 
in  the  operating  ratio  for  the  6  towns  applies  before  there  has  been  an 
increase  of  $42,000  due  to  internal  improvements,  or  after.  The  problem 
seems  to  imply  that  this  reduction  is  quite  independent  of  the  reduction  of 
2%  in  operating  ratio  for  the  entire  properties  following  the  total  increase 
of  gross  earnings.  We  will  assume  that  the  internal  improvements  are  all 
made  before  September  i,  19 16,  since  the  wording  is  "amount  to  be  spent 
immediately  for  betterments."  Consequently  the  operating  expenses  for 
the  6  towrs  alone  would,  for  the  year  from  September  i,  1916,  to  September 
I,  1917,  be  55%  of  $293,200  ($251,200  gross  for  1915  plus  $42,000  addi- 
tional due  to  internal  betterments),  or  approximately  $161,300.     This 

ir>        ^jfii         T^  ^  $339.000+ x  + 364,600     - 

*  Computed  as  follows:  Let  x  represent  1914-     — ^^—^ =  $3S3,8oo. 


378  APPENDIX 

leaves  net  earnings  of  $131,900  for  the  6  towns  alone,  for  the  year  in  ques 
tion. 

The  operating  ratio  for  Galesboro  for  1915  was  46%  approximately. 
The  operating  expenses  for  the  year  from  September  i,  19 16,  to  September 
I,  191 7,  would  be  $178,200 — without  considering  the  additional  $400. 
This  would  increase  the  operating  expenses  to  $179,600.  It  would  leave 
net  earnings  for  Galesboro  of  $210,100.  Putting  these  figures  together 
(and  still  omitting  from  consideration  the  general  reduction  of  2%  in 
operating  expenses)  we  have: 


Gross 

Operating  Expenses 

Net 

Galesboro 

. , .$387,400 

$178,600 

$208,800 

Six  Towns  . . . 

. .  .  .293,200 

161,300 

131,900 

Totals $680,600  $339,900  $340,700 

This  represents  an  operating  ratio  of  50%.  There  will  be  a  reduction  of 
2%  for  the  entire  consolidated  property — 48%.  This  will  bring  about  the 
following  estimated  statement  of  the  entire  consolidation  for  the  year 
from  September  i,  191 6,  to  September  i,  191 7: 

Gross  Earnings $680,600 

Operating  Expenses 326,700 

Net  Earnings $353,900 

We  may  now  proceed  to  the  discussion  of  the  financial  plan  of  the  new 
consolidation.  The  bankers  have  before  them  3  possible  general  plans, 
subject  to  almost  an  infinite  nimiber  of  modifications. 

1.  Advance,  either  themselves  or  through  a  syndicate,  enough  money 

to  carry  out  the  promotion.  Hold  the  securities  until  the  es- 
timated earnings  are  actually  realized. 

2.  Pay  ofif  all  the  bonds  and  create  an  entirely  new  financial  plan. 

Enough  of  these  new  securities  would  then  be  sold  to  furnish 
the  money  to  pay  the  bonds  and  make  the  improvements. 

3.  Form  a  holding  company  which  would  own  only  the  equities  in  the 

7  subsidiaries.  All  the  underlying  bonds,  so  far  as  possible, 
and  the  preferred  stock  of  the  Galesboro  Electric  Power  Com- 
pany would  remain  outstanding.  Holding  company  bonds  and 
stocks  would  be  sold  to  obtain  money  for  the  minimimi  cash 
requirements. 

A  comparison  of  these  general  plans  shows  that  the  first  involves  the 
greatest  risk  to  the  bankers.    It  would  bring,  however,  in  case  the  esti- 


PROBLEMS  379 

mated  earnings  were  actually  realized,  the  bankers  and  presumably  the 
promoter,  the  greatest  profit.  The  second  plan  would  involve  the  largest 
immediate  cash  requirement,  the  third  plan  the  least  cash  requirement. 

The  spring  of  1916  afforded  an  excellent  market  for  securities.  High- 
grade  public  utility  bonds  commanded  a  4.80%  market,  good  grade  a 
5.10%  market,  medium  grade  a  5.45%  market.  Bankers  would  recognize 
this.  They  would  wish  to  take  advantage  of  it.  They  would  therefore  dis- 
card the  first  plan  of  a  carrying  syndicate. 

The  execution  of  either  of  the  second  plans  would  involve  the  immedi- 
ate sale  of  securities.  These  securities  would  be  sold  on  the  basis  of  past 
earnings  and  future  prospects.  Let  us  consider  exactly  what  is  the  outlook 
for  new  securities  on  the  basis  of  past  earnings  only. 

Provided  the  Galesboro,  Belgrade,  Clifton, and  Sumpter  bonds  are  not 
paid  or  refunded,  they  will  require  a  fixed  charge  of  $86,180  a  year,  to 
which  must  be  added  the  preferred  stock  dividend  on  the  Galesboro  6% 
preferred  stock,  $24,000,  making  $1 10,180  of  fixed  and  contingent  charges 
ahead  of  any  charges  to  be  created  in  paying  for  the  properties  and  im- 
provements. The  properties  and  improvements  will  require  $957,000, 
aside  from  the  underlying  seciirities  mentioned  in  the  preceding  sentence. 
Granting,  for  the  purposes  of ' '  trying  out ' '  a  plan,  that  this  money  will  cost 
the  new  company  6%,  the  added  charges  are  $57,420,  making  a  total 
charge  of  $167,600,  to  compare  with  actual  net  earnings  of  $281,200  and 
prospective  earnings  of  $353,900.  This  was  not,  even  in  19 16,  a  particu- 
larly strong  showing  upon  which  to  issue  definite  securities.  It  could  be 
used,  however,  provided  the  cash  to  be  raised  was  small  in  amount  and  the 
bonds  sold  to  obtain  the  cash  secured  by  a  first  mortgage — without  prior 
lien — on  the  entire  property. 

The  Galesboro  bonds  were  stronger  than  any  bonds  likely  to  be  issued 
by  the  consolidated  company.  They  must  be  either  paid  oflf  or  exchanged 
into  new  securities  on  a  very  favorable  basis.  This  applies  with  less  force 
to  the  Galesboro  preferred  stock. 

The  Belgrade  and  Sumpter  bonds,  yielding  only  4%  and  representing 
unsubstantial  liens  on  small  properties,  could  surely  be  exchanged  into 
new  bonds.  Owing  to  the  narrow  margin  of  earnings  available,  the  Clifton 
bonds  could  be  exchanged  on  about  an  even  basis.  A  small  premium  or 
discount,  either  way,  on  the  refunding  of  these  three  small  bond  issues 
would  not  be  of  much  importance  in  determining  the  general  financial 
plan. 

On  the  basis  of  past  earnings  only,  $2,800,000  of  5%  first  mortgage 
bonds  could  be  issued,  since  bonds  of  a  public  utility  such  as  this  should 


38o  APPENDIX 

show  past  earnings  at  least  twice  interest  charges.  This  would  absorb 
$140,000.  Preferred  stock  to  such  an  amount  could  be  issued  that  the 
dividend  would  not  absorb  more  than  a  third  to  two-fifths  of  the  remaining 
earnings.  This  would  permit  the  issue  of  $750,000,  7%  preferred  stock. 
The  amount  of  common  stock  is  unimportant,  except  to  the  holders  of  the 
$300,000  common  stock  of  Galesboro  not  held  by  Stetson  and  Sampson. 
An  equitable  adjustment  of  this  will  be  discussed  presently. 

We  have  therefore  the  following  senior  securities  to  use  in  the  promo- 
tion: 

First  Mortgage  20- Year  5%  Bonds $2,800,000 

Preferred  Stock  7% 750,000 

An  offer  is  now  made  to  the  holders  of  the  $1,000,000  Galesboro  bonds 
to  exchange  them,  par  for  par,  into  the  new  bonds  together  with  a  cash 
bonus  of  10% ,  or  $100  a  bond.  This  would  enable  the  holders  to  mark  their 
bonds  down  to  83>2.  A  medium-grade  5%  public  utility  bond,  showing 
net  earnings  of  twice  interest  charges,  was  worth  about  88  in  the  spring  of 
1 9 16.  We  will  assume,  therefore,  that  the  proposition  is  accepted  by  some 
95%  of  the  bondholders.  The  remaining  5%  of  bonds  are  called  at  105 
and  the  Galesboro  mortgage  is  canceled. 

The  holders  of  the  Belgrade,  Clifton ,  and  Sumpter  bonds  are  offered  par 
in  new  bonds.  The  offer  is  accepted,  with  the  exception  of  the  holders  of 
$6,000  par  value  of  bonds.  This  amount  of  money  is  deposited  with  the 
respective  trustees  and  then  the  mortgages  are  canceled. 

These  refunding  operations  absorb  $1,786,000  of  new  bonds,  and  cost 
as  follows: 

Bonus  to  $950,000  Galesboro  Bonds $95,000 

Calling  $50,000  Galesboro  Bonds 52,500 

Deposit  on  Small  Bond  Issues 6,000 

$153,500 

As  stated  earlier,  the  properties  and  the  contemplated  improvements 
will  cost  $957,000  in  money  (aside  from  the  bonds  to  be  refunded  and  the 
Galesboro  common  and  preferred  stocks).  With  the  money  required  for 
the  bond  refunding,  there  must  be  raised  $1,110,500. 

The  preferred  stockholders  of  the  Galesboro  Company  are  offered  new 
7%  preferred  stock  in  exchange  for  their  old  6%  preferred  stock. 
The  bankers  who  placed  the  Galesboro  preferred  stock  are  given  5% 
bonus  in  new  preferred  stock  for  effecting  the  exchange.    Sampson  and 


PROBLEMS  381 

Company  will  purchase  this  bonus  at  80%,  so  that  the  bankers  can  receive 
a  cash  commission  of  4%.  All  the  preferred  stock  is  exchanged.  It  ab- 
sorbs $262 , 500  of  the  preferred  stock.  There  remains,  therefore,  $1 ,0 1 4,000 
in  new  bonds  and  $487,500  in  new  preferred  stock  with  which  to  raise 
$1,110,500  in  money.  The  bonds,  the  entire  remainder,  arc  sold  to  M.  U. 
Harlow  and  Company,  who  bought  the  original  Galesboro  bonds,  for  85%. 
This  sale  gave  the  promoters  $861 ,900.  The  promoters  then  sold  $300,000 
of  the  preferred  stock  for  87%.  This  yielded  the  company  $261,000.  The 
total  money  realized  from  the  sale  of  securities  was,  therefore,  $1,122,900, 
ample  to  meet  the  actual  money  requirements.  The  unsold  preferred  stock 
passed  into  the  treasurj'  of  the  new  company. 

Some  nominal  amount  of  common  stock  was  issued.  This  was  deter- 
mined by  the  exigencies  of  the  situation.  Suppose  an  issue  of  13,000,000 
was  used.  On  the  basis  of  the  past  earnings  this  issue  of  common  stock 
showed,  after  fixed  and  contingent  charges,  about  3%.  The  common  stock 
of  the  Galesboro  Company  showed  earnings  of  about  8%.  The  holders  of 
the  $300,000  par  value,  just  one -fifth  interest  of  Galesboro  common  stock 
not  held  by  Stetson  and  the  Sampson  firm ,  were  offered  2  shares  of  new 
common  stock  for  one  share  of  Galesboro,  a  one-fifth  interest  in  the  new 
company.  The  offer  was  unanimously  accepted.  This  required  the  issue 
of  |6oo,ooo  new  common  stock.  The  remaining  $2,400,000  was  divided 
equally  between  Stetson  and  William  Sampson  and  Company. 

In  this  particular  solution  of  the  problem  it  is  assumed  that  a  5%  first 
mortgage,  20-year,  public  utility  bond  could  be  sold  to  the  public  at  about 
90.  This  was  true  in  the  spring  of  19 16.  It  certainly  was  not  in  the  spring 
of  1 9 2 1 .  If,  therefore,  no  available  market  exists  for  the  bonds,  some  other 
means  must  be  found  of  furnishing  the  proportion  of  the  cash  requirement 
that,  had  a  market  existed,  would  have  been  realized  from  the  sale  of  the 
bonds  and  preferred  stock. 

If  interest  rates  are  such  that  new  first  mortgage  bonds  cannot  be  sold 
except  on  an  8%  or  8^4%  basis,  as  in  the  spring  of  192 1,  some  other  solu- 
tion of  the  problem  would  have  to  be  adopted. 

The  course  adopted  in  such  a  case  would  depend  on  the  confidence  of 
the  promoters  in  their  estimate  of  the  earnings  for  the  year  after  the  im- 
provements were  completed,  in  this  case  the  year  ending  September  i, 
191 7,  and  upon  their  belief  regarding  the  future  course  of  interest  rates. 
Assuming  that  they  had  implicit  confidence  in  their  estimates  and  believed 
interest  rates  were  falling,  the  promoters  might  wisely  secure  the  necessary 
money  by  the  issue  of  7%  2-year  notes  at  98.  The  best  course  in  such  a 
case  would  probably  be  to  secure  the  refunding  of  all  the  underlying  bonds. 


382  APPENDIX 

in  the  manner  described  in  the  solution  of  the  problem,  and  then  to  hold  tha 
remaining  $1,014,000  bonds  in  the  treasury  of  the  new  corporation.  The 
promoter  would  then  issue  $1,200,000,  8%  second  mortgage  2-year  notes, 
junior  to  the  bonds,  but  senior  to  the  preferred  stock.  At  the  end  of  the 
2  years,  provided  the  promoters'  estimates  of  earnings  were  actually  real- 
ized, the  treasury  bonds  could  be  sold  to  meet  part  or  all  the  notes.  Mean- 
time, too,  the  increased  earnings  will  have  made  easier  the  sale  of  the 
preferred  stock  held  in  the  treasury. 

In  case  the  promoters  have  not  implicit  confidence  in  their  prediction 
of  earnings,  and  if  they  do  not  care  to  assume  the  risk  of  the  issue  of  short- 
term  notes,  then  the  "block"  plan  should  be  used.  In  such  a  case  the 
amount  of  the  issue  of  the  common  stock  should  be  further  increased  so 
that  an  apparently  liberal  bonus  of  common  stock  may  be  given  away 
without  jeopardizing  the  control  of  the  company  by  the  promoters  and 
bankers. 

40.  Engineers  discovered  a  water  power  in  Arkansas  capable,  on  develop- 
ment, of  producing  28,000  h.p.  of  electrical  energy  at  a  net  cost — mainte- 
nance, labor,  and  superintendence — at  the  switchboard  of  only  $12,000  a 
year.  The  river  above  the  fall  ran  through  steep  banks  so  that  the  cost  of 
development  was  very  small,  about  $1,750,000,  or  less  than  $65  per  horse 
power.  But  there  were  few  consumers  within  50  miles  of  the  falls.  The 
engineer  planned  to  attract  mamifacturing  industries  that  used  large 
amounts  of  electrical  energy  to  locate  at  or  near  the  development  and  to 
sell  them  energy  at  a  very  low  rate.  There  are  nimierous  metallurgical 
processes  that  can  be  used  only  when  an  abundance  of  cheap  electrical 
energy  is  available.  The  engineer  had  seciired  an  agreement  from  one  of 
these  to  construct  a  plant  at  the  fall  which  would  use  10,000,000  k.  w.  h. 
a  year  at  a  price  not  to  exceed  i  cent.  He  had  other  industries  in  prospect, 
the  total  gross  revenue  from  which  might  reach  as  high  as  $200,000  for  the 
first  year. 

Construct  a  financial  plan  by  which  bankers  could  obtain  the  requisite 
$1,750,000  required  from  the  public. 

**  41.  The  Tompkins  Falls  Power  Company  was  promoted  in  19 13  and 
its  hydroelectric  development  at  Tompkins  Falls  on  the  Ocmulgec  River 
was  finished  in  191 5.  It  was  successful  from  the  first.  It  was  found  pos- 
sible to  develop  considerably  more  electric  energy  than  could  be  profitably 
sold  in  the  immediate  environs.  Twenty-seven  miles  away  were  4  small 
electric  light  companies,  located  at  Burleyville,  McGregor,  Milford,  and 
Adams  Center. 


PROBLEMS 


383 


Milford,  the  largest,  was  geographically  the  center  of  the  group  and 
the  other  3  were  all  located  within  3  miles  of  Milford.  Burleyville  had  a 
large  chair  factory  and  was  connected  by  a  small  unprofitable  electric 
railway  with  the  center  of  Milford.  Each  town  had  its  separate  steam 
electric  generating  plant  and  the  Milford  and  Burleyville  Railway  Com- 
pany also  had  its  own  steam  plant.  The  management  of  the  Tompkins 
Falls  Power  Company  proposed  to  acquire  the  4  electric  companies  (but 
not  the  street  railway)  and  to  form  the  Cascade  Power  Company,  the 
latter  to  acquire  all  the  property  previously  owned  by  the  Tompkins  Falls 
Power  Company  and  the  4  distributing  companies.  Each  of  these  has 
been  reasonably  successful,  although  increasing  costs  of  coal  have  dimin- 
ished the  net  profits  of  the  4  distributing  companies.  Great  economies 
are  therefore  expected  to  result  from  closing  the  separate  steam  generating 
stations  and  connecting  all  the  distributing  systems  with  the  hydroelectric 
company. 

The  following  represents  the  capitalization  of  the  5  companies  just 
before  the  organization  of  the  Cascade  Power  Company: 


Tompkins 
Falls 

Burleyville 

McGregor 

Milford 

Adams 
Center 

$2,000,000  s's 
600,000  n.c.  6% 
3,000,000 

$160,000  6's 

None 

250,000 

$  450,000  s's 

None 

1,000,000 

$1,000,000  s's 
500,000  c.  7% 
00,000 

Preferred  Stock.  . 
Common  Stock. . 

None 
$60,000 

Earnings 

(Even  ooo) 

Average  s  Years 

Tompkins 
Falls 

Burleyville 

McGregor 

Milford 

Adams 
Center 

$583,000 
340,000 

$28,000 
14,000 

$187,000 
64,000 

$337,000 
153.000 

$38,000 
9,000 

Net 

Preceding  Year 
(Even  000) 

Tompkins 
Falls 

Burleyville 

McGregor 

Milford 

Adams 
Center 

$684,000 
417,000 

$36,000 
15,000 

$219,000 
61,000 

$401,000 
162,000 

$40,000 

Net 

384  APPENDIX 

The  Adams  Center  plant  was  owned  by  a  man,  Simons  by  name> 
wealthy  for  that  neighborhood,  now  66  years  of  age.  He  had  just  previous- 
ly married  a  young  lady  of  2  2,  who  wished  to  leave  the  prosaic  surroundings 
of  Adams  Center.  Accordingly  Simons  offered  to  sell  the  property  for 
$40,000  cash.  The  preferred  stockholders  of  Tompkins  Falls  and  Milford 
were  each  offered  new  7%  preferred  stock  in  the  Cascade  Power  Company. 
The  bondholders  of  each  of  the  companies  were  offered  80%  in  cash  for 
their  bonds  or  the  privilege  of  exchanging  them  for  the  5%  first  mortgage 
bonds  of  the  Cascade  Power  Company,  "when,  as  and  if"  issued  together 
with  a  bonus  of  2>^%. 

Engineers  estimated  that  the  transmission  lines  necessary  to  connect 
the  hydroelectric  generating  station  to  each  of  the  distributing  systems 
together  with  the  necessary  substations  will  cost  in  actual  investment 
$117,000.  It  will  require  $27,000  to  revamp  the  distributing  system  at 
Adams  Center.  $292,000  should  be  spent  during  the  first  year  in  the  other 
3  towns.  This  would  increase  the  gross  earnings  of  the  4  distributing  com- 
panies by  27%.  In  addition,  the  electric  railway  company  agreed  to  buy 
not  less  than  500,000  k.w.h.  a  year  at  2.15  cents  metered  on  the  primary  side 
at  the  Milford  substation.  Without  reference  to  the  capital  charges,  but 
including  line  and  transformer  losses,  electricity  so  delivered  would  cost 
the  company  .73  cents.  Without  reference  to  the  street  railway  contract 
the  changes  and  improvements  enumerated  would  reduce  the  operating 
ratio  of  the  4  distributing  companies  by  13%.  The  normal  annual  in- 
crease of  the  gross  earnings  of  the  hydroelectric  company  alone  had  been 
9%,  and  engineers  estimated  that  the  cost  of  operation  for  the  territory 
and  customers  previously  served  by  it  alone  would  be  decreased  after  the 
consolidation  by  iK%- 

Prepare  a  financial  plan  for  the  promotion  of  the  Cascade  Power 
Company. 

*4  2 .  Three  men  undertake  the  promotion  of  a  hydroelectric  power  devel- 
opment in  northern  New  York  State.  An  engineer  whom  they  have  em- 
ployed, reports  the  following  essential  facts :  A  river  with  a  natural  fall  of 
6  feet  and  rough  water  for  half  a  mile  above  the  falls  can  be  developed  by 
building  a  cement  dam  at  or  near  the  natural  fall.  This  will  cost,  without 
machinery,  $278,000.  Land  on  both  sides  of  the  natural  fall  sufficient  to 
give  control  and  to  erect  a  power  station  upon  can  be  acquired  for  $67,000. 
The  land  on  both  sides  of  the  river,  above  the  falls,  will  have  to  be  acquired 
or  condemned.  It  will  involve  costs  and  settlements  of  at  least  $81,000. 
Six  miles  above  the  rough  water  the  river  spreads  out  over  a  large  meadow. 


PROBLEMS  385 

This  must  be  acquired  or  condemned  at  a  cost  of  $32,000,  and  the  dam  site 
and  dam  for  impounding  the  water  will  cost  $17,000.  It  will  also  be  neces- 
sary to  acquire  the  land  about  the  outlet  of  the  river  from  a  large  pond,  in 
order  to  control  the  flow,  at  a  cost  of  $6,000;  and  damage  suits  from  owners 
of  timber,  flowed  from  damming  the  outlet  of  the  pond,  might  run  to 
$20,000.  These  expenses,  however,  would  not  have  to  be  met  at  the  time 
of  promotion.    The  equipment  costs  would  be  about  as  follows: 

Water  wheel  machinery  and  installation,  and  electrical  generating 
machinery  and  power-house  would  amount  to  $136,000.  The  rights  of  way 
and  construction  of  a  transmission  line  of  32  miles  for  33,000  volts,  to- 
gether with  the  transformers,  will  cost  $118,000.  Engineers  estimate  that 
with  the  pondage  and  storage  obtained  from  the  large  pond  and  the 
meadow  dam  the  installation  will  develop  2, 7  80  electrical  horse  power  at  an 
average  of  1 8  hours  per  day  for  the  entire  year.  In  add  ition  there  would  be 
at  least  1,250  horse  power  during  at  least  8  months  of  the  year.  At  the  end  of 
the  32-mile  transmission  line  is  a  city  of  10,000  inhabitants.  The  promoters 
obtained  an  option  on  the  securities  of  the  electric  light  company  in  that 
city  on  the  following  terms:  $185,000  par  value  of  first  mortgage  5%  bonds 
at  86,  $go,ooo  par  value  of  6%  preferred  stock  at  88 ,  and  $200,000  par  value 
of  common  stock  at  62.  The  preferred  stock  had  no  accumulated  divi- 
dends and  the  common  stock  was  then  paying  4%  a  year  in  dividends. 
Electricity  was  generated  by  a  steam  station  of  fair  efficiency,  buUt  about 
7  years  before.  It  had  one  k.  w.  G.  E.  turbine  7  years  old,  and  one  500 
k.  w.  G.  E.  turbine  installed  the  year  before. 

The  earnings  of  the  company  were  as  follows: 

Next  Next 

Previous  Year  Preceding  Year  Preceding  Year 

Gross  Earnings $106,000  $98,000  $81,000 

Operating  Expense . .         74,000  67,000  53,000 

Net  Earnings 32,000  31,000  28,000 

The  company  had  sold  2,684,000  k.w.h.  electricity  during  the  pre- 
ceding year,  but  the  load  factor  was  poor.  There  were  3  knitting  mills  in 
the  immediate  locality  of  the  city.  These  would  purchase  their  power  of 
the  new  development  at  2  cents  a  k.w.h.,  and  agree  to  take  at  least  1,000,- 
000  k.w.h.  annually  altogether.  The  company  could  sell  its  entire  surplus 
or  secondary  power  at  i  cent  per  k.w.h. 

The  promoters  decide  to  buy  the  distributing  system  and  proceed  to 
develop  the  water  power.  A  new  company  is  formed  to  absorb  the  old 
electric  company  and  carry  on  the  development. 

Outline  a  financial  plan. 


386  APPENDIX 

Chapter  X — The  Underwriting  Syndicate 

43.  The  Kentucky  Eastern  Electric  Company,  a  consolidation  of  9  small 
electric  companies  and  a  hydroelectric  company,  has  just  contracted  with 
Monson  and  Company  of  New  York  to  sell  to  them  $4,000,000  first  mort- 
gage 6%  bonds  for  Sj}4.  Monson  and  Company  form  a  syndicate  to 
acquire  these  bonds  from  themselves  at  89.  The  syndicate  agreement 
specifies  that  underwriters  are  to  begin  to  offer  the  bonds  to  the  public  at 
94  on  April  i ,  and  that  the  syndicate  will  close  on  or  before  May  i .  Mem- 
bers will  receive  a  selling  commission  of  3  points  on  all  the  bonds  they  sell 
and  will  participate  in  the  profits  and  losses  on  the  syndicate  operations, 
as  of  May  i.  James  IMason  and  Company  of  Buffalo  participated  to  the 
extent  of  $100,000.  On  April  23  the  managers  announced  that  all  the 
bonds  had  been  disposed  of.  At  that  time  James  Mason  and  Company 
had  sold  $65,000.     Compute  their  gross  profit. 

Suppose  Monson  and  Company  had  participated  to  the  extent  of 
$500,000  in  their  own  syndicate  and  had  actually  sold  $627,000  at  the 
time  of  clostire.  Compute  their  gross  profit  from  the  Kentucky  Eastern 
electric  business. 

44.  There  was  a  boom  period  of  the  textile  business,  during  the  later 
part  of  and  immediately  following  the  Great  War.  It  was  followed  in  the 
summer  and  autumn  of  1920  by  a  very  marked  reaction.  At  the  height  of 
the  boom  the  Continental  Woolen  Company  offered  to  sell  to  its  stock- 
holders $20,000,000  new  common  stock  at  par.  The  stock  was  then  selling 
at  about  $112  a  share  and  had  sold  immediately  before  as  high  as  $140  a 
share.  A  syndicate  was  formed  which,  for  a  commission  of  2^4%,  imder- 
wrote  the  stockholders'  subscriptions.  The  market  for  the  stock  continued 
to  fall  and  only  40%  of  the  subscription  was  taken  by  stockholders.  In 
order  to  protect  the  market  the  syndicate  managers  had  bought  73,000 
shares  in  the  open  market  at  prices  ranging  from  loi  down  to  87,  an  aver- 
age of  963  8-  Finally  after  a  series  of  postponements  the  syndicate  was 
dissolved.  Meanwhile  the  managers  had  paid  $1 56,000  in  interest  for  carry- 
ing the  syndicate  commitments  and  no  dividends  had  been  received.  The 
stock,  at  the  time  of  the  dissolution,  was  selling  at  $53  a  share.  Harrison 
and  Company  of  Cleveland  had  subscribed  to  $250,000  of  the  under- 
writing. 

What  was  their  actual  profit  or  loss,  as  computed  on  the  current  market 
value  of  the  stock  at  the  time  of  settlement? 

Omit  from  consideration  syndicate  manager's  commission. 


PROBLEMS  387 

45.  The  Central  Railroad  wished  to  insvire  the  successful  sale  to  its  own 
stockholders  of  $  roc, 000,000,  6%  debenture  bonds  at  par.  Accordingly 
an  underwriting  syndicate  was  formed  by  James  B.  Manson  and  Company, 
acting  as  managers.  They  received  }i  oi  1%  commissicn  for  forming  the 
syndicate,  and  the  underwriters  were  paid  2%  on  their  commitments. 
Eustis  and  Company  of  Syracuse  underwrote  |6o,ooo  of  the  debentures. 
The  subscription  was  taken  up  entirely  by  the  stockholders. 

(a)  What  was  Eustis  and  Company's  profit  or  loss? 

(b)  Suppose  the  stockholders  subscribed  for  only  $6C;00o,ooo  of  the 
debentures  and  the  managers  sold  the  remainder  on  the  open  market  and 
in  Europe  at  an  average  of  90%.    What  was  their  profit  or  loss? 

Chapter  XTI — Repairs,  Depreciation,  and  Obsolescence 

46.  The  Newark,  Maine,  Gas  Company  found  that  a  considerable  pro- 
portion of  the  repairs  to  its  mains  and  structures  could  be  done  most  eco- 
nomically in  the  months  of  June,  July,  and  August  when  the  ground  was 
free  from  frost,  the  weather  settled,  and  labor  relatively  plentiful.  Owing  to 
the  severity  of  the  cold,  repairs  to  mains  cost,  by  actual  computation,  from 
3  to  4  times  as  much  if  made  in  the  middle  of  winter  compared  with  the 
same  repairs  if  made  in  the  summer.  But  the  policy  of  making  repairs  only 
in  summer  created  such  large  fluctuations  in  the  repair  charges  as  to  ab- 
normally increase  the  earnings  during  the  winter  months  and  to  abnor- 
mally decrease  the  earnings  during  the  summer  months.  To  avoid  this  the 
directors,  at  their  meeting  of  December  18,  1919,  appropriated  $15,000 
out  of  earnings  for  the  forthcoming  year  to  be  used  for  repairs,  the  sum  of 
$1,250  to  be  charged  against  the  earnings  of  each  month.  The  following 
were  the  expenditures  for  repairs  during  the  year  1920:  January,  $638; 
February,  $1,371;  March,  $311;  April,  $442;  May,  $932;  June,  $3,161; 
July,  $1,430;  August,  $1,571;  September,  $1,211;  October,  $931;  Novem- 
ber, $219;  December,  $398. 

How  would  you  treat,  on  the  balance  sheet  of  December  31,  1920,  any 
discrepancies  between  the  allotted  repair  charges  and  the  actual  repair 
charges? 

47.  The  Milford  and  Springfield  Railroad,  operating  in  New  England, 
has  found  that  its  untreated  cross  ties  decay,  or  become  of  no  further  use,  in 
seven  years.  The  road  encounters  a  bad  year,  after  having  operated  for  a 
long  period  with  ample  but  not  inoidinately  liberal  maintenance  allow- 
ances.    In  the  endeavor  to  reduce  expenses  the  superintendent  ot  mainte- 


388  APPENDIX 

nance  of  ways  and  stmctures  appropriated  $107,000  for  the  purchase  of  ties, 
a  reduction  of  $13,000  from  the  appropriation  of  the  previous  year. 

But  in  the  meantime  the  prices  which  the  road  was  forced  to  pay  the 
farmers  for  ties  was  raised  15  cents  for  No.  i  and  11  cents  for  No.  2.  In 
consequence  the  road  replaced  one-tenth  of  all  its  ties. 

Could  or  should  its  treatment  of  tie  replacements  be  made  to  show  on 
its  balance  sheet  at  the  end  of  the  year?    Explain  your  answer. 

48.  The  following  is  the  balance  sheet  as  of  December  31,  19 17,  of  the 
Conway  Manufacturing  Company,  in  existence  for  8  years: 

Assets  Liabilities 

Land  (cost) $  12,300      Capital  Stock $500,000 

Building  (cost) 1 17,480      Notes  Payable 30,000 

Machinery  (cost) 318,710      Accounts  Payable 19,317 

Inventories 279,414  Depreciation  Reserve.  .  . .  131,123 

Notes  and  Accounts  Rec. .  137,618      Surplus 212,400 

Cash 27,318 


)2,840  $892,840 


The  income  account  for  the  year  1918,  before  dividends  and  deprecia 
tion,  was  as  follows : 

Total  Gross  Profits  after  Adjustments  for  Inventories, 
Returns,  and  Bad  Debts $218,973 

The  accountants  required  that  the  buildings  be  considered  to  have  had, 
when  built,  a  life  of  20  years  and  the  machinery  a  life  of  10  years.  But  new 
machinery  and  large  building  improvements  could  be  substituted  for  de- 
preciation. During  the  year  in  question  a  new  store  house  was  built  at  a 
cost  of  $2,718  and  new  machinery  was  installed  at  a  cost  of  $16,752.  A 
dividend  of  10%  was  paid  and  the  rest  of  the  earnings  added  to  surplus. 

Give  a  possible  balance  sheet  for  December  31,  191 8,  improvising  rea- 
sonable entries  where  necessary. 

49.  The  Endicott  Coimty  Electric  Company,  having  fixed  assets  of 
$1,764,000,  when  built  in  1910  sold  an  issue  of  $1,500,000,  5%  bonds  to  an 
investment  house  whose  attorneys  inserted  in  the  indenture  the  provision 
that  the  company  must  set  aside  3%  of  gross  earnings  each  year  as  a  de- 
preciation reserve.    The  following  gross  earnings  were  obtained: 


PROBLEMS  389 

191 1 $156,872 

1912 162,512 

1913 172,660 

1914 170,117 

1915 159.131 

1916 184,284 

1917 210,653 

At  the  beginning  of  19 18  the  property — there  having  been  no  important 
capital  improvements  made  in  the  meantime — was  acquired  by  the  Inter- 
County  Power  and  Light  Company.  The  management  paid  off  the  out- 
standing bond  issue,  thus  relieving  the  company  of  the  3%  depreciation 
obUgation.  Arthur  Gray  and  Company,  accountants,  were  employed  to 
reorganize  the  accounting  system.  They  condemned  with  great  severity 
the  method  previously  followed  in  computing  the  annual  depreciation,  and 
suggested  that  accountants  go  back  over  the  books  and  re-establish  a  de- 
preciation reserve  on  the  assumption  that  a  4%  annual  reserve  on  the 
original  cost  of  the  entire  property  would  have  been  proper.  This  was 
done. 

What  adjusting  entries  would  have  been  necessary?  Construct  a 
reasonable  and  proper  balance  sheet  for  the  Endicott  County  Company 
when  taken  over  by  the  Inter-County  Company,  and  a  second  balance 
sheet  after  the  advice  of  Arthur  Gray  and  Company  had  been  followed. 

50.  The  Paugus  Mill,  a  60,000  spindle  medium  goods  cotton  mill,  was 
constructed  in  Fall  River.  $25,000  was  paid  for  land;  $216,000  was  paid 
to  the  contractors  for  the  erection  of  the  buildings;  $109,000  to  a  firm  of 
engineers  for  the  installation  of  a  power  plant  and  power  transmission 
machinery;  $739,000  was  paid  for  machinery  covering  the  various  proc- 
esses for  the  manufacture  of  cotton  cloth.  At  the  end  of  the  first  year 
Johnson,  McHugh  and  Company,  mill  engineers,  estimated  that  the 
proper  depreciation  charges  were:  structures,  5%;  power  plant  and  trans- 
mission machinery,  7^%;  and  cotton  machinery,  10%.  The  profits,  before 
depreciation  and  dividends,  for  the  first  year  were  $117,318. 

What  were  the  net  earnings  before  dividends? 

*  5 1 .  James  Fleming,  an  engineer,  made  the  following  report  to  a  firm  of 
accountants  about  to  open  the  books  of  The  Sandy  Lake  Electric  Com- 
pany, with  reference  to  the  requisite  depreciation  and  obsolescence  charges. 

The  management,  in  order  to  protect  their  company  against  competi- 
tion of  more  efficient  plants  in  later  years,  wished  to  set  up  a  reserve  not 
only  for  depreciation  but  also  for  the  obsolescence  of  equipment. 


390 


APPENDIX 


On  the  basis  of  Fleming's  report,  what  should  be  the  annual  charges  for 
both  depreciation  and  obsolescence? 


Probable    Number 

Cost 
(Approximate) 

Average  Life 

Under  Normal 

Conditions 

Years  It  May  Be 
Used  Before    It 
Will  Be  Expedi- 
ent OR  Economi- 
cal TO  Substitute 
Improved  Models 

PoWER-HoUSE 

Buildings 

$42,000 

40  years 

50  years 

Boilers,       Super- 

heaters, etc 

27,000 

20  years 

15  years 

Generating  Machin- 

ery    (Exciters, 

Steam    Turbines 

and  Condensers) . . 

48,000 

15  years 

10  years 

All  Other  Equipment 

to    the    Transfor- 

mer Platform.  .  .  . 

18,000 

20  years 

20  years 

Transmission  Lines 

Transformers,  etc. .  . 

9,000 

12  years 

Poles     (Including 

Pole  Hardware)... 

7,000 

15  years 

Wire 

16,000 

Distribution 

Meters 

6,000 

10  years 

Small  Transformers 

2,000 

10  years 

Secondary  and  Ser- 

vices   

8,000 

50  years 

*52.  James  Hardy  and  Company  are  manufacturers  of  jewelry  specialties 
in  Attleboro,  Mass.  Their  accountants  decide  that  they  should  make  a  gen- 
eral charge  of  2]/^%  to  cover  the  depreciation  on  their  buildings  costing 
$85,000  and  7>^%  on  their  machinery  and  equipment  costing  $115,000, 
Mr.  Hardy,  however,  is  not  satisfied  with  this  rough  method.  The  business 
uses  certain  special  machinery  which  is  being  constantly  improved  upon. 
Since  the  industry  is  a  highly  competitive  one  it  is  necessary  to  substitute 
improved  machinery  as  soon  as  this  is  put  upon  the  market  in  order  to  keep 


PROBLEMS  391 

down  the  manufacturing  costs.  During  the  40  years  of  his  business  experi- 
ence as  a  manufacturing  jeweler  he  noted  that  these  substitutions  occur  in 
certain  of  the  processes  with  greater  frequency  than  in  others.  For  ex- 
ample, he  observes  that  of  the  $115,000  invested  in  machinery,  at  least 
$35,000  is  invested  in  well-standardized  machines  which  have  not  changed 
significantly  during  the  last  40  years.  On  the  other  hand  it  has  been  neces- 
sary to  discard  certain  special  machines,  costing  $25,000  on  an  average  of 
every  5  years.  About  $40,000  of  other  more  or  less  specialized  types  have 
to  be  discarded  and  improved  models  installed  about  once  in  10  years. 
The  economical  operation  of  the  remainder  of  the  machinery  is  not  of  such 
great  importance  as  to  require  the  substitution  of  improved  models  before 
it  is  worn  out.  Mr.  Hardy  passes  a  memorandum  covering  these  observa- 
tions to  his  accountants  and  asks  them  to  recompute  the  depreciation 
charge,  taking  full  account  of  the  obsolescence  of  his  machinery. 

What  change  must  they  make,  if  any,  in  their  original  computation? 

Chapter  XIII — Payments  on  Account  of  Borrowed  Capital 

53.  The  Peterboro  Electric  Company  had  a  plant  that  cost  in  1908, 
including  all  fixed  assets,  $1,385,000.  It  had  common  capital  stock  of 
$900,000  par  value;  and  the  company  issued  as  of  January  i,  1908,  $750,- 
000  first  mortgage  25-year  5%  bonds.  These  were  sold  to  bankers  at  75. 
During  1913  the  company  paid  5%  interest  throughout  the  year  on  a  float- 
ing debt  which  began  as  of  January  i,  1913,  at  $113,000,  and  slowly  but 
steadily  increased  until  it  reached  $129,000  at  the  end  of  the  year.  The 
profit  before  interest  charges,  but  after  depreciation,  taxes,  and  all  other 
"out-of-pocket"  expenses,  was  $94,387. 

What  was  the  net  profit  available  for  dividends? 

54.  The  Mercantile  Manufacturing  Company  decided  that  it  would  be 
wise  to  secure  $2,000,000  of  new  capital  in  order  to  liquidate  a  portion  of 
its  unfunded  debt.  The  directors  at  their  meeting  of  April  3,  1916,  de- 
cided to  issue  bonds.  A  banking  house  with  which  the  treasurer  entered 
into  correspondence  offered  to  buy  6%  20-year  first  mortgage  bonds  for 
1 1 5,  20-year  5%  bonds  at  98>^,  or  20-year  4%  bonds  at  80.  The  account- 
ants acting  for  the  firm  insisted  that  bond  discount  or  bond  premium 
should  be  extinguished  by  equal  annual  instalments,  i.e.,  without  refer- 
ence to  interest  on  either  accumulated  reserves  or  unextinguished  pre- 
miums. Which  offer  of  the  banking  house  should  the  corporation 
accept? 


392  APPENDIX 

55.  There  were  two  small  factories  located  in  Haverhill,  Massachusetts, 
each  making  the  same  line  of  goods — ladies'  turn  slippers.  The  quantity 
output  of  the  factories  was  approximately  the  same  and  in  many  other 
respects  the  two  businesses  were  closely  analogous.  Goldmann  had,  at  the 
beginning  of  1913,  a  personal  investment  in  the  business  of  $6,715 — the 
accumulation  of  his  previous  savings.  On  the  other  hand,  Kingsburg's 
personal  investment  amounted  at  the  beginning  of  1913  to  $16,81 7  and  on 
that  date  he  took  in  a  partner,  Stein  by  name,  who  immediately  invested 
$10,000  in  the  business. 

At  the  end  of  1913  the  proprietors  handed  their  profit  and  loss  state- 
ments to  John  Stiles,  the  cashier  of  the  Haverhill  National  Bank,  who  in 
turn  presented  them  to  the  full  board  of  directors.  Stiles  explained  to  the 
board  that  the  shoe  business  during  the  year  had  been  good,  and  the  pro- 
prietors of  each  of  the  two  businesses  requested  an  increase  of  their  re- 
spective lines  of  credit.  An  argument  then  ensued  between  two  of  the 
directors  as  to  which  business  had  been  the  more  successful.  Discuss  this 
problem. 

Statf.mknt  of  Year  Ending  December,  19 13  (even  000) 

Kingsburg 
Goldmann      and  Stein 

Total  Receipts  less  Trade  Discounts $218,000        $246,000 

Labor,  Materials,  Royalties,  and  Rentals 188,000  221,000 

Gross  Profit $  30,000  $  25,000 

Depreciation  and  Repair  of  Machinery  Owned 1,000  3,000 

Bank  Discounts 7,000  2,000 

Proprietors,  Drawn  out 20,000  8,000 

Increase  of  Net  Worth $     2,000       $  12,000 

56.  The  two  slipper  businesses  described  in  the  preceding  problem  con- 
tinued to  be  fairly  successful,  and  in  191 5  Kingsburg  and  Stein  were  in- 
corporated with  a  capital  stock  of  $200,000.  Goldmann  continued  to 
operate  his  business  alone.  As  of  January  1,1916,  the  Kingsburg  and  Stein 
Company  sold  $100,000  debenture  bonds,  due  January  i,  1926,  to  their 
friends  at  90%.  Part  of  this  money  was  invested  in  the  equity  in  a  factory 
building  of  their  own,  and  part  was  used  for  expansion.  The  following  are 
some  of  the  important  entries  in  connection  with  their  income  and  ex- 
penditure account  as  of  December  31,  192 1  (even  000): 


PROBLEMS 


393 


Gross  Sales,  less  Trade  Discounts $1,670,000 

Labor,  Material,  and  Royalties 1,485,000 

Salaries  to  Kingsburg  and  Stein 30,000 

Taxes 2,000 

Repairs 1,000 

Enlargement  to  Building 4,000 

Interest  on  Mortgage 6,000 

Bank  Discount 17,000 

Depreciation  to  Building  and  Machinery  Owned 2,000 

Determine  the  net  profit  for  the  year. 

Chapter  XIV — ^The  Corporate  Surplus 

57.  The  income  accounts,  abbreviated,  of  a  wire  mill,  after  all  charges 
were  as  follows: 


Gross  Profit,  after  all  Manu- 
facturing Costs 

Interest  on  $4,000,000  5% 
Mortgage  Bonds 

Discount  on  Bonds 

Dividend  on  $3,000,000  Pre- 
ferred Stock  

Dividends  on  $5,000,000  Com- 
mon Stock 


1908 


$1,375,000 


200,000 
87,000 


$1,007,000 


200,000 
87,000 


$962,000 

200,000 
87,000 


$2,873,000 


200,000 
87,000 


$1,214,000 

200,000 
87,000 

210,000 

300,000 


At  the  meeting  of  the  board  of  directors,  called  for  the  purpose  of 
declaring  the  second  semiannual  dividend  in  the  autumn  of  1913,  one  of 
the  directors  proposed  the  declaration  of  an  extra  dividend.  At  this  point 
the  treasurer  stated  that  the  depreciation  reserve  had  been  continuously 
underestimated;  as  a  result,  $850,000  ought  to  be  added  to  it.  At  the  same 
time  the  directors  decided  that  $28,000,  profit  on  the  sale  of  real  estate, 
should  be  taken  away  from  surplus. 

What  might  the  accountant  do  with  this  profit  on  real  estate  so  that  it 
would  not  appear  in  the  surplus  account?    What  was  the  adjusted  surplus? 

Chapter  XV — Insurance  and  Special  Reserves 

58.  The  Cape  Ann  Fisheries  Company  maintained  its  own  fleet  of 
fishing  vessels.  There  were  118  vessels  of  all  sizes  and  of  varying  ages  and 
values.  Several  vessels  were  40  years  old  and  hardly  seaworthy ;  there  were 
several  large  vessels  less  than  a  year  old. 


394  APPENDIX 

The  company,  as  of  January  i,  1907,  adopted  the  policy  of  self-insur- 
ance, transferring  immediately  a  sum  of  $200,000  from  the  general  surplus 
account  to  insurance  reserve  account.  Thereafter  it  credited  to  this  ac- 
count the  sum  of  $15,000  annually  out  of  earnings.  All  its  vessel  property 
was  properly  depreciated  from  year  to  year. 

Thecompany  suffered  no  vessel  loss  in  1907  or  1908.  In  1909  one  vessel 
was  lost  which  had  a  book  value,  after  depreciation,  of  $27,000.  No  loss 
occurred  in  1910.  In  191 1  a  small,  old  vessel  having  a  depreciated  value 
of  $7,000  was  lost.  In  1912  three  vessels  were  lost — one  worth  $65,000, 
another  $28,000,  and  a  third  having  a  depreciated  book  value  of  $19,000. 
There  were  no  losses  in  1913  and  1914.  In  1915  there  was  a  loss  of  $17,000, 
and  none  in  1916.  During  this  time  the  company  received  4.8%  interest 
on  the  funds  represented  by  its  insurance  reserve. 

What  was  the  condition  of  this  reserve  account  after  a  period  of  10  years? 

59.  The  Sudbury  and  Osterville  Railroad  reported  to  the  Public 
Utility  Commission  for  its  fiscal  year  ending  June  30,  1921.  After  depre- 
ciation, adequate  maintenance,  interest  charges  of  all  kinds,  but  before 
all  taxes,  there  remained  net  earnings  $107,000,  of  which  $58,000  accrued 
during  the  preceding  6  months.  Analogous  earnings  for  the  preceding  year 
were  $104,000,  of  which  $55,000  accrued  during  the  last  half-year.  On 
October  20,  1920,  the  treasurer  had  paid  $16,000  in  taxes  to  the  towns  and 
municipalities  through  which  the  road  passed,  covering  local  taxes  for  the 
taxable  year  beginning  April  i,  1920.  For  the  year  from  April  i,  1919, 
the  local  taxes  had  amounted  to  $14,000,  and  for  the  year  before  that  to 
$12,000.  The  amount  of  taxes  were  never  known  before  September  15 
of  the  current  year.  The  state  through  which  the  road  passed  levied  a 
capital  stock  tax  of  $1  per  $1,000,  in  lieu  of  all  franchise  taxes.  The 
federal  government  assessed  in  March  corporate  income  taxes  of  1920 
on  the  net  earnings,  exclusive  of  all  taxes  and  assessments,  for  1920. 
These  income  taxes  were  payable  in  four  equal  instalments  March  15, 
June  15,  September  15,  and  December  15.  The  road  had  $1,000,000  of 
common  and  $416,000  of  preferred  stock. 

What  was  the  actual  net  income  for  the  year  ending  June  30,  192 1? 

60.  The  Muddy  Creek  Coal  Company  was  organized  in  1908.  In  1910, 
in  order  to  purchase  and  develop  an  adjacent  coal  property,  the  directors 
issued  $1,500,000,  20-year,  6%  gold  bonds.  The  bankers  required  the  in- 
sertion of  a  sinking  fund  clause  which  required  that  the  company  must 
set  aside  5  cents  a  ton  for  every  ton  of  coal  mined  and  that  the  fund 
must  amount  to  at  least  $45,000  a  year. 


PROBLEMS 


395 


The  sinking  fund  was  to  be  invested  in  bonds  purchased  at  the  market 
price. 

In  1912  the  company  mined  1,687,534  tons  of  coal.  During  January, 
1913,  when  bonds  were  acquired  for  the  sinking  fund,  the  market  price  was 
about  86K- 

How  many  bonds  were  acquired? 

61.  The  Interurban  Consolidated  Traction  Company,  a  holding  corpor- 
ation organized  under  the  laws  of  Delaware,  owns  the  stocks,  debentures, 
notes,  and  certain  mortgage  bonds  of  a  group  of  traction  companies  operat- 
ing in  Illinois. 

The  Interurban  Company  issued  in  191 7,  $3,685,000  first  lien  col- 
lateral trust  6%  bonds  secured  by  all  its  treasury  assets.  The  col- 
lateral trust  agreement  under  which  these  bonds  were  issued  provided 
that  a  fund  consisting  of  2%  of  the  gross  earnings  shall  be  set  aside  each 
year  for  the  purchase  at  the  market  price  of  either  bonds  of  this  issue,  or 
else  bonds  of  the  underlying  companies  senior  to  it. 

The  following  is  a  balance  sheet  of  the  Interurban  Consolidated  Trac- 
tion Company  as  of  December  31,  19 18  (even  000)  and  before  the  acquisi- 
tion of  bonds  for  the  sinking  fund: 


Assets 

Property  Account 

Bonds  in  Treasury : 

Decatur  and  George- 
town 6's 

Cairo  and  Eastern. . . 

Illinois  and  Southern 

Interurban  Collateral 

6's 

Accrued     Interest     on 

Treasury  Bonds 

Materials 

Advance  Payments 

Discount  on  Bonds  less 

Profit  from  Purchase 

of  Treasury  Assets. . . 
Deferred  Assets,  Misc. 


113.295,000 


402,000 
23,000 
98,000 

13,000 

7,000 

248,000 

8,000 


85,000 
16,000 


$14,195,000 


Liabilities 

Decattu-  and  George- 
town 6's  1924 

Cairo  and  Eastern  4's 

1949 

Illinois  and  Southern 
6's  1930 

Interurban  Traction 
Company  Collateral 
Trust  40- Year  6's 
1957 

Debenture  Notes  7's 
1923 

Bills  and  Accounts  Pay- 
able   

Interest  Accrued 

Preferred  Stock  6% 
Cumulative 

Common  Stock 

Surplus 


$  516,000 
768,000 
310,000 

3,685,000 

1 ,000,000 

165,000 
76,000 

2,000,000 

5,000,000 

675,000 

$14,195,000 


396  APPENDIX 

December  31, 191 8,  the  bonds  of  the  Decatur  and  Georgetown  could  be 
bought  in  the  open  market  for  92;  the  6%  bonds  of  the  Illinois  and  South- 
ern could  be  bought  in  the  open  market  for  98  and  the  4%  bonds  of  the 
Cairo  and  Eastern  could  be  bought  for  76,  while  the  first  lien  collateral  6's 
of  the  Interurban  Consolidated  Traction  Company  itself  could  be  bought 
for  par. 

The  following  represents  the  income  account  for  the  preceding  year: 

Gross  Income $2,273,675.30 

Operating  Expenses 1,492,414.65 

Considering  all  things — economy,  saving  in  amortization,  an  increase  of 
security  of  the  junior  securities  of  the  Interurban  Consolidated  Traction 
Company — in  what  manner  should  the  sinking  fund  be  invested? 

*  Recast  the  balance  sheet  given  above  after  these  purchases  have  been 
made. 

Chapter  XVI— The  Stockholders'  Surplus 

62.  The  Perkins  Manufacturing  Company  was  organized  in  191 7  to 
manufacture  fabricated  tinware.  Eleazer  H.  Perkins  had  been  the  factory 
superintendent  of  a  large  and  well-known  Connecticut  business  engaged 
in  the  same  line  of  production.  He  had  secured  the  financial  backing  of 
certain  relatives  and  friends.  The  business  had  prospered.  At  the  end  of 
1920  Perkins  presented  the  following  statement: 

Total  Sales $876,000 

Cost  of  Manufacture,  including  Taxes,  etc 704,000 

Interest  on  Bank  Loans 67,000 

Net  Profits  before  Dividends 105,000 

Dividends  on  Preferred  Stock 35.ooo 

Surplus  Available  tor  Dividends  on  $1,000,000  Common  Stock  $  70,000 

Should  a  dividend  be  declared  on  the  common  stock? 

*  63.  James  Whiting,  the  American-bom  son  of  an  immigrant  mule  spin- 
ner who  came  from  Lancashire  to  New  Bedford  in  1847,  has  been  working 
in  the  Sanborn  yam  mill  since  he  was  1 1  years  of  age.  He  is  now  33,  has 
gained  a  thorough  technical  knowledge  of  the  manufacture  of  fine  yams , 
and  meanwhile  he  has  attended  the  local  textile  school,  evenings.  He  has 
shown  remarkable  mechanical  ingenuity ,  as  is  attested  by  the  fact  that  he 
received  a  patent  on  an  improved  winder  for  which  a  machinery  manu- 
facturer paid  him  $10,000. 


PROBLEMS  397 

Two  years  before  a  local  capitalist,  connected  with  a  Boston  commis- 
sion house,  being  impressed  with  the  man's  ability,  secured  subscriptions 
to  $1,000,000  in  money  in  order  to  build  a  yarn  mill.  The  capitalist, 
Avery  by  name,  became  president  and  Whiting  treasurer.  Avery's  com- 
mission house  assumed  responsibility  for  selling  the  yams  and  the  entire 
management  of  the  mill  was  turned  over  to  Whiting. 

The  mill  cost  $786,000  in  money  to  erect.  Seventy-four  thousand  dol- 
lars was  subscribed  by  a  Providence  machinery  house  making  the  total 
capital  invested  in  the  enterprise — its  net  worth  at  the  beginning — 
$1,074,000. 

The  balance  sheet  when  the  mill  was  opened  stood  as  follows: 


Plant 

Cotton.  .  .  . 

Cash 

Good- Will.. 

Assets 

.     $   786,000 

82,000 

206,000 

1,000,000 

Liabilities 
Capital  Stock 

Preferred  7%  Cumu- 
lative  

Common 

$1,074,000 
1,000,000 

$2,074,000 

$2,074,000 

The  preferred  stock,  representing  actual  money  investment,  is  owned  as 


follows : 


Avery,  personally $100,000 

Avery,  Green  and  Co 300,000 

Whiting,  personally 100,000 

(This  amount  constituted  Whiting's  entire  savings 
of  $17,000  and  $83,000  loaned  to  Whiting  by  Avery, 
who  took  Whiting's  preferred  and  common  stock  in 
the  Whiting  Mills,  Inc.  as  collateral.) 

Avery's  Personal  Friends 165,000 

Whiting's  Friends,  Associates  and  Small  Investors 
of  New  Bedford  who  Invested  on  the  Strength  of 

Whiting's  Reputation 175,000 

Local  New  Bedford  Bankers 135,000 

A  New  York  Yarn  Merchant 25,000 

Providence  Machinery  Manufacturer 74,000 

$1,074,000 


The  $1,000,000  of  common  stock  was  divided  equally  between  Avery 
and  his  commission  house  on  the  one  hand  and  Whiting  on  the  other 
hand. 


398 


APPENDIX 


At  the  end  of  the  first  year  Whiting  presented  to  the  board  of  direc- 
tors of  the  mill  the  following  income  accotmt  and  balance  sheet  before 
dividends. 


Gross  Profits  after  Returns,  Inventory  Adjustments,  etc. 

Depreciation  4%  of  Original  Cost , 

Interest  Payments,  Bank  Discounts , 


;?i6i,8i2 
31,440 
12,916 

Net  Profits $117,456 


Assets 


Plant 

Cotton 

Goods   in  Process 

Finished 

Accounts  Receivable . 

Cash 

Good- Will 


and 


$    786,000 
109,117 

213,918 

301,715 

38,716 

1,000,000 

$2,449,466 


Liabilities 

Capital  Stock 

Preferred  7%  Cum..  . 

Common 

Depreciation , 

Notes  Payable , 

Surplus 


$1,074,000 

1,000,000 

31,440 

226,570 

117,456 

$2,449,466 


At  the  time  the  preferred  stock  was  subscribed,  Whiting  and  Avery 
stated  that  no  dividend,  preferred  or  common,  should  be  paid  until  the  end 
of  the  first  year  and  then  only  if  the  earnings  fully  warranted  it.  Every 
subscriber  understood  the  cotton  yam  business. 

At  the  directors'  meeting  Avery's  partner ,  Green ,  moved  that  a  dividend 
of  7%  be  declared  and  paid  on  the  preferred  stock  and  1%  on  the  common 
out  of  the  earnings  of  the  first  year.  Avery  objected  to  the  payment  of  the 
dividend  on  the  common  stock,  but  would  not  vote  against  the  preferred 
dividend  if  the  rest  of  the  board  of  directors  so  voted.  Whiting  stated  that 
he  was  opposed  to  any  dividends  whatever.  Thereupon  a  three-cornered 
argument  ensued  between  Green,  Avery,  and  Whiting. 

State  under  appropriate  headings  the  arguments  advanced  by  each. 

With  whom  would  you  have  voted  and  what  was  the  strongest 
argiunent  advanced?  (Consider  yourself  a  director  having  a  small  pre- 
ferred stock  interest  and  permanently  interested  in  the  welfare  of  the 
mill.) 

64.  An  expert  rubber  chemist,  James  Mayer  by  name,  commenced  the 
business  of  manufacturing  rubber  specialties,  in  19 10.  Twenty-five  thou- 
sand dollars  was  loaned  to  him  by  his  father-in-law ,  who  accepted  his  note. 
The  local  bank  in  Binghamton,  where  the  business  was  started,  loaned 
him  $10,000. 


PROBLEMS 


399 


The  business  was  a  success  from  the  beginning.  By  191 6  Mayer  had 
paid  off  his  father-in-law  and  increased  the  net  worth  of  his  business  to 
$1 18,000.  At  that  time  he  decided  to  incorporate  his  business  and  erect  a 
small  tire  factory  in  Akron,  Ohio.  He  planned  to  concentrate  his  efforts 
on  the  manufacture  of  a  special  hand-made  tire  using  a  special  patented 
"zinc"  process  and  a  coarse  fabric  carcus  made  out  of  selected  combed 
Egyptian  cotton.  To  carry  out  his  plans  Mayer  required  at  least  $1,000,- 
000,  $125,000  of  which  he  could  secure  from  selling  his  Binghamton  fac- 
tory and  liquidating  the  quick  assets  of  the  business.  The  remaining 
$875,000  was  promised  him  by  a  firm  of  Cleveland  bankers  through  the 
organization  of  a  small  syndicate.  These  plans  were  carried  out  and  by  the 
autumn  of  191 7  a  small  but  thoroughly  modem  and  efficient  factory  had 
been  built  in  Akron  and  the  business  started.  The  $1,000,000  of  actual 
money  was  represented  by  7%  cvunulative  preferred  stock.  In  addition 
$500,000  in  common  stock  was  issued  to  Mayer  and  the  same  amount  to 
the  syndicate  of  bankers  who  furnished  him  with  the  greater  part  of  the 
capital. 

This  business,  too,  was  a  success  from  the  very  begiiming.  During 
1918,  the  first  full  year,  the  Mayer  Manufacturing  Company  made  on 
gross  sales  of  $1,967,000  a  net  profit,  after  reasonable  charges  to  deprecia- 
tion, of  $171,918.  From  this  preferred  dividends  of  $70,000  were  paid  and 
the  remainder  carried  to  surplus  and  reinvested  in  the  business.  The  year 
191 9  was  very  successful  also,  and  the  business  during  the  first  five  months 
of  1920  was  of  unprecedented  volume.  On  June  i,  1920,  the  company 
showed  the  following  monthly  balance  sheet  (even  000) : 


Assets 

Liabilities 

Plant 

$1 

,218,000 

Capital  Stock 

Good-Will 

I 

,000,000 

Preferred  7%  Cumu- 
lative   

Rubber,   Cotton  Fabric 

$1,000,000 

and  Other  Materials . . 

310,000 

Common 

1,000,000 

Goods    in    Process    and 

Notes  Payable,  Banks . . . 

350,000 

Finished  Tires  (Akron) 

216,000 

Foreign  Drafts 

74,000 

Tires    on    Consignment 

Accounts  Payable 

289,000 

with    Special    Agents 

Depreciation  Reserve . . . 

42,000 

and  Service  Stations. . 

93,000 

Profit  and  Loss 

262,000 

Customers'  Notes 

84,000 

Customers'    Open    Ac- 

counts   

59,000 

Cash 

37,000 

$3 

2= 

,017,000 

$3,017,000 

400         •  APPENDIX 

President  Mayer  reported  to  the  directors  at  the  meeting  of  June  8, 
that  the  company's  policy  was  to  place  a  reasonable  number  of  tires  in  the 
hands  of  special  agents  who  featured  the  Mayer  tire  at  the  exclusion  of 
other  makes.  In  addition  to  their  consignments,  however,  the  company 
had  then  on  hand  actual  orders  from  retail  dealers  and  garages  sufficient 
not  only  to  exhaust  the  present  stock  of  finished  goods  in  the  Akron  ware- 
house but  to  keep  the  factory  in  full  operation  until  August  1 5.  The  orders 
booked  for  the  first  week  in  June  were  165%  of  the  orders  booked  during 
the  first  week  of  June,  1919.  There  had  been  a  steady  rise  in  the  wholesale 
prices  of  plantation  rubber  and  Egyptian  cotton,  and  President  Mayer 
expressed  the  belief  that  rising  prices  of  raw  materials  would  continue 
throughout  the  year.  He  desired,  therefore,  the  authority  of  his  board  for 
entering  immediately  into  contracts  with  importers  of  crude  rubber  and 
cotton  fabric  mills  to  cover  all  the  orders  now  on  hand  and  the  probable 
normal  demand  up  to  October  i.  This  would  involve  contracts  of  about 
$380,000  at  the  then  prevailing  prices.  The  board  of  directors  voted  the 
authority  without  discussion. 

The  rate  of  new  orders  began  to  decline  slightly  on  June  17.  By  July  i , 
cancellations  of  orders,  a  factor  never  before  reckoned  with,  began  to  ap- 
pear and  at  the  same  time  the  automobile  industry,  upon  which  the  tire 
industry  is  directly  dependent,  sustained  a  sudden  collapse.  Mayer, 
following  the  authority  of  his  board,  had  odered  $118,000  worth  of  tire 
fabric  and  approximately  $93,000  of  crude  rubber.  On  June  23,  he  ceased 
to  place  further  orders  and  on  July  4  secured  the  cancellation  of  $37,000  of 
his  order  of  fabrics  (that  proportion  on  which  the  mills  had  not  themselves 
covered  on  raw  cotton).  He  could  not  honorably  repudiate  any  of  his 
crude  rubber  contracts,  and  he  did  not  try  to. 

By  September  i,  the  tire  business  had  suffered  a  complete  collapse. 
By  careful  planning  Mayer  had  been  able  to  dispose  of  a  considerable  pro- 
portion of  his  manufactured  stock  so  that  no  actual  loss  resulted.  He  had 
ceased  to  manufacture  altogether  about  August  20.  At  the  directors* 
meeting  of  September  7,  the  following  balance  sheet  was  presented: 

Assets  Liabilities 

Plant $1,218,000      Capital  Stock 

Good-Will 1,000,000           Preferred   7%   Cumu- 

Rubber,     Fabric     and                                     lati/e $1,000,000 

Other     Materials    on                                Common 1,000,000 

Hand    (cost   $116,000  Notes  Payable,  Banks. .  313,000 

at  Market) 67,000      Accounts  Payable 98,000 


PROBLEMS  4^1 

Tires  on  Hand  and  on  Depreciation  Reserve .. .  42,000 

Consignment  (80%  of  Profit  and  Loss 241,000 

Cost) 101,000 

Customers'  Notes  (prob- 
ably 95%  good) 162,000 

Customers'     Open    Ac- 
counts   81,000 

Cash 65,000 


$2,694,000  $2,694,000 


In  addition,  the  company  is  under  contract  to  receive  $27,000  worth 
of  fabric  (having  then  a  market  price  of  about  $21,000)  and  $62,000  worth 
of  crude  rubber  (then  having  a  replacement  value  of  about  $37,000). 
Both  the  fabric  and  rubber  markets  were  falling. 

The  president  stated  that  he  was  making  "special  offers"  and  the  like 
to  agents  with  the  result  that  his  stock  was  moving  on  the  whole  satisfac- 
torily although  the  prices  then  being  realized  were  about  85%  of  the  actual 
cost  of  manufacture.  He  hoped  to  re-open  by  October  i,  on  the  basis  of 
reduced  labor  and  material  cost.  He  felt  on  the  whole  encouraged  in  spite 
of  the  chaotic  conditions  of  the  crisis  through  which  he  was  then  passing. 
The  dividend  on  the  preferred  stock  had  always  been  paid.  He  asked  the 
directors  to  consider  the  advisability  of  paying  the  quarterly  dividend  of 
1)4%  due  October  i. 

What  is  your  judgment? 

Chapter  XVIII — Expansion  Among  Big  and  Little  Manufacturing  Concerns 

65.  There  are  three  small  jewelry  businesses  located  in  Lowell,  Massa- 
chusetts.   The  statements  for  the  preceding  year  are  as  follows: 

Johnson  Everett  Stuart  Brothers 

Tools $   450  $     680           $     916 

Merchandise 1,680  2,963                8,51 1 

Debts 318  o                2,717 

Total  Sales 6,817  I4.7i  i              3v'i.654 

Cost  of  Merchandise,  Rent,  and  Labor. .        6,139  9.613              31.329 

It  is  planned  to  form  a  corporation  to  be  called  Johnson,  Stuart  and 
Everett,  Inc.  All  the  debts  are  to  be  paid,  personally,  by  the  new  president, 
Solomon  P.  Stuart,  who  will  take  a  5-year  note  in  return.  Assuming  the 
data  given  above  represent  a  fair  index  of  the  three  businesses,  what  ani 
the  proportions  of  common  stock  that  should  be  distributed  to  the  three 
constituent  businesses? 
26 


402  APPENDIX 

66.  In  the  city  of  Worcester,  Massachusetts,  in  1917,  there  were  7  small 
custom  foundries  and  drop  forges,  each  doing  a  relatively  small  business. 
Owing  to  the  hectic  prosperity  of  the  metals  trades  in  the  United  States, 
everyone  of  these  small  shops  had  more  orders  for  work  than  it  could  exe- 
cute. One  of  the  younger  men,  Thomas  Gilson  by  name,  thought  of  the 
idea  of  combining  them  into  a  single  corporation.  Gilson,  an  expert  in  the 
manufacture  of  small  drop  forgings,  knew  nothing  about  finance.  He  did 
have  the  conviction,  however,  that  if  the  7  competing  forges  and  foundries 
were  united  under  one  management,  each  unit  could  specialize  in  a  special 
type  of  orders.  He  thought  over  the  matter  a  long  time,  and  finally  went  to 
a  young  investment  banker  who  had  married  a  schoolmate  of  his  wife's. 
The  banker,  Edward  Halladay  of  Halladay,  Richards  and  Company, 
offered  to  try  to  effect  the  consolidation,  to  meet  all  the  expenses  incident 
to  the  undertaking,  including  attorneys'  and  lawyers'  fees,  in  return  for  a 
fee  of  10%  of  the  common  stock  of  the  consolidation.  Halladay  called  a 
meeting  of  the  proprietors  and  partners  of  the  7  foundries  and  forges  at 
which,  having  been  properly  coached  by  Gilson,  he  explained  the  advant- 
ages of  consolidation.  Among  these  advantages  he  enumerated:  collective 
purchases  of  iron  and  coal;  a  uniform  and  stronger  policy  of  dealing  with 
labor  unions;  distribution  of  orders  to  the  foundry  or  forge  best  able  to 
take  care  of  them;  easier  access  to  bank  credit;  and  better  credit  with  the 
fiuTiace  men.  Halladay's  talk  made  a  favorable  impression,  but  the  men 
were  skeptical  about  the  possibility  of  arranging  terms  suitable  to  all  7 
of  the  owners.  Halladay  proposed  different  plans  all  looking  to  the  form- 
ation of  a  corporation  having  only  preferred  and  common  stock.  The  plans 
differed  only  in  the  manner  in  which  the  preferred  and  common  stock 
was  distributed  among  the  owners  of  the  plants. 

Outline  4  different  plans  that  might  have  been  suggested. 

*  67.  There  were  4  carpet  mills  located  within  60  miles  of  each  other. 
The  following  is  a  brief  description: 

The  Cartersville  Mill.  The  corporation,  organized  in  1897,  owned  a 
small  modem  mill  devoted  to  the  manufacture  of  inexpensive  ingrain  car- 
pets. James  Edgarson  built  the  mill  and  was  the  largest  stockholder  in 
the  corporation — in  fact  all  the  stock  was  held  by  Edgarson,  his  wife,  his 
uncle,  and  their  very  close  friends.  Edgarson  had  made  a  great  deal  of 
money  from  the  mill  and  had  withdrawn  the  earnings  each  year  and  in- 
vested them  in  high-grade  municipal  bonds.  The  mill  had  never  been  en- 
larged or  extended.  Edgarson,  now  62  years  of  age,  wished  to  retire 
altogether  from  the  business  and  move  to  California. 


PROBLEMS  403 

The  Empire  Corporation.  Organized  in  191 2.  This  mill  was  about  the 
same  size  as  the  Cartersville  mill,  but  had  larger  liabilities  at  the  banks. 
It  was  owned  by  a  group  of  Philadelphia  men  and  managed  by  John 
Towner.  He  was  about  38  years  of  age  and  then  recognized  as  distinctly 
the  ablest  carpet  man  among  the  younger  men.  He  had  the  absolute  con- 
fidence of  his  stockholders  and  associates.  He  was  ambitious,  keen,  un- 
married, and  his  business  was  his  one  and  only  thought. 

The  Sawyer  Manufacturing  Company  and  the  Climax  mills.  Small 
carpet  mills  owned  by  about  the  same  people,  although  the  managements 
were  separate.  The  Sawyer  mill  was  located  in  the  same  town  as  the  Em- 
pire. It  was  the  oldest  mill  of  the  entire  group,  built  over  50  years  before, 
antiquated  and  inefficient.  But  its  brand , "  The  Chesterfield  Wiltons ,"  was 
highly  esteemed  in  the  trade.  The  Climax  mill  had  been  acquired  6  years 
before  at  a  receiver's  sale  by  the  3  largest  stockholders  of  the  Sawyer  mill. 
During  the  6  years  it  had  been  operated  by  them,  it  had  made  a  little 
money.    The  plant  was  antiquated  and  not  capable  of  efficient  operation. 

Towner  approached  Alden  Richardson,  the  largest  single  stockholder 
of  the  Empire  Corporation  and  a  man  of  large  means,  with  the  plan  of  ac- 
quiring the  Cartersville,  Sawyer,  and  Climax  mills,  and  organizing  a  new 
corporation.  Richardson  promised  to  back  Towner  in  the  undertaking  to 
the  extent  of  $500,000.  He  also  promised  to  secixre  for  him  the  co-opera- 
tion of  Wilkins  and  Company,  bankers. 

Towner  secured  an  option  from  Edgarson  to  be  exercised  within  90 
days,  covering  the  entire  stock  of  the  Cartersville  mill  for  the  sum  of 
$1,200,000,  from  which  would  be  deducted  an  amount  equivalent  to  any 
bank  or  merchandise  loans  outstanding  at  the  time  the  option  was  exer- 
cised and  increased  by  an  amoimt  equal  to  the  actual  cash  in  the  treasury. 
But  Edgarson  guaranteed  that  there  would  be  at  least  $500,000  net  quick 
assets.  The  money  would  have  to  be  paid  within  30  days  of  the  time  the 
option  was  exercised.  Towner  also  secured  an  option  on  86%  of  the  com- 
mon "one  class"  stocks  of  the  Sawyer  and  Climax  mills,  to  be  bought  at 
$72  and  $3  7 .  50  a  share  respectively.  Neither  could,  however,  be  purchased 
separately. 

Wilkins  and  Company  after  several  interviews  promised  to  furnish 
money  up  to  a  maximum  of  $1,500,000  under  the  following  5  conditions: 

I.  The  money  they  supply  to  be  represented  by  an  issue  of  7%  pre- 
ferred stock,  none  of  which  issue  shall  be  given  to  any  mill  owner 
or  sold  to  any  banker.  The  bankers  will  purchase  the  stock  at 
90%. 


404 


APPENDIX 


2.  $500,000  in  money  be  subscribed  by  Richardson ,  who  shall  receive 

second  preferred  stock  to  the  extent  of  $500,000  par  value  and  a 
bonus  of  common  stock. 

3.  Common  stock  only  shall  be  given  the  stockholders  of  the  Empire 

Corporation. 

4.  Towner  to  sign  a  contract  to  remain  with  the  new  corporation  for 

at  least  3  years. 

5.  The  net  quick  assets  of  the  consolidated  company  shall  be  at  least 

$600,000  to  start  with  and  must  at  all  times  remain  at  least  a 
third  as  much  as  the  outstanding  first  preferred  stock. 

These  terms  were  agreed  upon  by  Towner  and  Richardson,  who  forth- 
with prepared  a  plan  of  consolidation  to  be  presented  to  the  stockholders  of 
the  Empire  Corporation. 

The  consolidated  company  was  to  be  called  "The  Towner  Corporation." 
The  following  represent,  in  abbreviated  form,  the  balance  sheets  of  the 
four  companies  (even  000) : 

Assets 


Cartersville 

Empire 

Sawyer 

Climax 

Plant 

$   873,000 

592,000 

318,000 

82,000 

$   994,000 

417,000 

294,000 

17,000 

$365,000 

284,000 

97,000 

3,000 

$219,000 

Inventories     (wool,    finished 

and  unfinished  goods) 

Accounts 

1 1 1 ,000 
32,000 

Cash 

12,000 

$1,865,000 

$1,722,000 

$749,000 

$374,000 

Liabilities 


Cartersville 

Empire 

Sawyer 

Climax 

Capital  Stock: 

Preferred 

$    400,000 
400,000 
216,000 
200,000 
38,000 
6 1 1 ,000 

$    700,000 

300,000 

28,000 

485,000 

198,000 

11,000 

$500,000 

115,000 
8 1 ,000 
53,000 

Common 

$250,000 
1,000 

Depreciation 

Bank  Notes 

100,000 

Accounts 

2 1 ,000 

Surplus 

2,000 

$1,865,000 

$1,722,000 

$749,000 

$374,000 

PROBLEMS  405 

Prepare  a  plan  of  consolidation  such  as  will  enlist  the  aid  of  Wilkins 
and  Company  and  also  be  fair  to  the  shareholders,  preferred  and  com- 
mon, of  the  Empire  Corporation.  Indicate  the  final  disposition  of  all  the 
stock  of  The  Towner  Corporation. 

Chapter  XIX — Railroad  Expansion 

68.  The  Eastern  Central  Railroad  required  the  Gray's  Point  road  to 
reach  tidewater.  On  the  other  hand  the  Gray's  Point  road  could  not  even 
meet  its  operating  expenses — much  less  its  interest  charges — were  it  not  for 
the  very  favorable  traffic  agreement  covering  the  interchange  of  freight  exe- 
cuted 24  years  before  when  the  Eastern  Central  was  an  insignificant  road, 
directly  and  explicitly  dependent  on  the  Gray's  Point  connection  for  over 
60%  of  its  traffic  interchange.  Meanwhile,  the  Eastern  Central,  through 
consolidation  and  intensive  development,  had  become  an  important  rail- 
road, while  the  Gray's  Point  and  Heron  Bay  Railroad  had  remained  a 
purely  local  enterprise,  stagnant  and  self-satisfied.  Within  a  year  the 
traffic  agreement  by  which  alone  it  could  maintain  its  existence  would 
expire. 

It  was  clear  that  no  choice  was  left  for  the  Gray's  Point  road  but  to 
accept  the  terms  proffered  by  the  Eastern  Central.  Already  the  president 
of  the  latter  road  had  intimated  to  Moses  CoUinwood,  octogenarian  and 
principal  stockholder  of  the  Gray's  Point  and  Heron  Bay,  that  imless  ar- 
rangement could  be  made  for  consolidation  of  the  2  roads,  the  Eastern 
Central  would  feel  constrained  to  build  its  own  line  to  tidewater  as  the 
directors  felt  that  the  water  terminal  facilities  should  be  improved  and  a 
more  aggressive  policy  followed  in  developing  rail  and  water  routes  over  the 
Eastern  Central. 

After  considerable  negotiation,  the  Eastern  Central  Railroad  made  a 
proposition  to  acquire  the  Gray's  Point  road  according  to  whichever  of  3 
plans  seemed  best  to  the  directors  and  stockholders  of  the  Gray's  Point 
road.  The  Eastern  Central  would  guarantee  the  interest  on  the  bonds  and 
guarantee  4%  dividends  in  perpetmty  on  the  stock  of  the  Gray's  Point 
road.  Or,  secondly,  it  would  acquire  the  stock  at  $72.50  a  share,  of  which 
I12.50  was  to  be  paid  in  cash  and  the  remainder  in  the  5%  collateral  trust 
bonds  of  the  Eastern  Central  Railroad,  secured  by  a  deposit  of  the  Gray's 
Point  stock  as  collateral.  Or,  again,  the  Eastern  Central  would  pay  a  lump 
sum  of  12,250,000  for  the  physical  property  of  the  road,  out  of  which  the 
Gray's  Point  directors  must  settle  with  their  own  bondholders  and  divide 
the  remainder  among  the  stockholders.  In  this  event,  the  Eastern  Central 
Railroad  had  planned  to  create  a  new  issue  of  5%  bonds,  to  be  secured  by 


406  APPENDIX 

a  first  mortgage  on  the  property  of  the  Gray's  Point  road  and  to  be  called 
the  Eastern  Central,  Gray's  Point  Division  first  mortgage  30-year  5's. 
Symons  and  Company  of  New  York  had  agreed  to  buy  $2,500,000  of  these 
bonds  at  90%  in  the  event  that  they  were  issued. 

Appended  are  the  principal  operating  statistics  of  the  Gray's  Point 
and  Heron  Bay  Raibroad  for  a  period  of  years,  and  balance  sheet  as  of  the 
first  of  the  month  preceding  the  offer  of  consolidation. 

Balance  Sheet 

Assets  Liabilities 

Cost  of  Road.  .  . .     $2,976,000       Capital  Stock $1,000,000 

First  Mortgage  4%  Bonds. . . .  1,000,000 
(27  years  to  run) 

Materials     and                             Second  Mortgage 6 %  Bonds. . .  700,000 

Supplies 37,469  (10  years  to  run) 

Cash 19,816       Bond  Interest  Accrued 10,000 

Material  and  Wages  Accrued. .  4,876 

Surplus 318,409 

$3,033,285  $3,033,285 


Were  you  a  director  of  the  Gray's  Point  and  Heron  Bay  Railroad, 
which  offer  would  you  vote  to  accept? 

Which  offer  should  CoUinwood  recommend  to  his  fellow  directors 
and  stockholders  that  they  should  accept? 

Which  offer  was,  on  the  whole,  the  best  for  the  interests  of  the  Eastern 
Central  Railroad? 

*69.  There  is  a  railroad  extending  west  from  Bowdoin,  a  city  of  48,000  in- 
habitants, to  Charlottestown,  a  raikoad  center  of  1 2,000  inhabitants.  The 
line  is  134  miles  in  length,  and  has  in  addition  4  branch  lines,  aggregating 
91.6  miles.  One  of  the  branches  reaches  into  an  important  manufacturing 
center  of  Greensboro.  Greensboro  is  on  one  of  the  main  east-west  lines 
of  the  Pennsylvania  Railroad,  so  that  the  Bowdoin  and  Charlottestown 
Railroad  gets  only  a  small  proportion  of  the  desirable  freight  out  of  Greens- 
boro. But  at  Charlottestown  it  connects  with  an  important  north-south 
line  of  the  New  York  Central  system.  The  latter  does  not  reach  Greens- 
boro directly  and  uses  the  Bowdoin  and  Charlottestown  Railroad  and  its 
Greensboro  branch  as  its  only  way  of  reaching  Greensboro.  The  amount  of 
freight  the  New  York  Central  turns  over  is  considerable  and  the  traffic 
contract  with  the  Central  is,  on  the  whole,  very  profitable. 


PROBLEMS 


407 


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408  APPENDIX 

The  president  of  the  Bowdoin  and  Charlottestown  Raih"oad,  Herbert 
Anderson  by  name,  was  an  able  railroad  executive,  well  thought  of  in  the 
locality.  He  was  a  friend  of  John  O'Brien,  the  division  superintendent  of 
the  Central  located  at  Charlottestown.  One  evening  in  the  winter  of  1920- 
192 1  O'Brien  met  Anderson  on  the  corner  of  Main  and  Mercer  streets  in 
Charlottestown,  and  the  following  conversation  ensued  after  the  usual 
preliminaries. 

O'Brien:    Just  been  talking  with  Danny  MacGregor,  and  he  said  they  are 
up  against  it  to  meet  their  pay-roll.    Blevins,  he  said,  had  gone  up  to  Pitts- 
burgh to  see  old  man  Peters.    Guess  the  old  shark  is  about  through, 
A  nderson:    If  I'd  buy  the  road  suppose  you  could  get  me  the  same  contract 
with  the  Central? 

O'Brien:    Sure,  only  you'd  have  to  still  call  it  the  B  and  C. 
Anderson:    That's  all  right. 

O'Brien:  So  long.  Don't  make  a  fool  of  yourself,  and  let  old  man  Peters 
put  it  over. 

Anderson:  So  long,  Johnny.  Don't  worry  about  me.  I  guess  Peters  can 
tend  his  own  chestnuts. 

Ten  days  later  Anderson  sought  out  O'Brien  at  the  letter's  home  and 
the  following  conversation  ensued: 

Anderson:    Well,  I've  bought  the  Charlottestown  and  Western. 
O'Brien:    What's  that! 

A  nderson:  Johnny,  old  boy,  when  I  was  in  school  back  in  the  old  farm  days 
in  Wayne  we  had  an  old  maid  teacher,  Mary  Stebbins.  We  boys  called  her 
Stebby .  One  day  I  pulled  Flossy  Kennifick's  pig  tail.  As  I  rode  down  to 
Pittsburgh  last  Thursday  the  train  stopped  at  the  Wayne  station,  and  I 
looked  across  and  saw  the  same  little  school  house,  and  the  children  were 
nmning  out  at  noon,  and  a  little  fellow  chased  a  girl  and  pulled  her  pig 
tail,  just  as  I  did  thirty  years  ago.  And  then  the  train  moved  and  I  didn't 
see  any  more,  but  when  I  pulled  Flossy's  hair  old  Stebby  made  me  stay 
after  school  and  copy  a  verse  of  poetry  ten  times.  And  the  first  line  went; 
"There  is  a  tide  in  the  affairs  of  men,"  and  the  rest  of  it  said  something 
about  taking  advantage  of  opportunity.  Then  I  got  to  thinking  how  little 
I'd  made  of  myself  and  how  much  opportunity  I'd  had  and  all  that  sort  of 
thing,  and  still  the  beginning  of  that  poetry  kept  running  in  my  mind. 
And  when  we  got  to  Pittsburgh  I  could  have  done  anything.  I  knew  now 
was  my  opportunity.    I'd  have  a  real  railroad.    I'd  be  somebody  instead  of 


PROBLEMS  409 

pegging  away  with  this  old  junk.  And  I  hurried  up  to  old  Peters'  office. 
He  was  alone,  reading  a  newspaper.    I  broke  right  in: 

"Mr.  Peters,  my  name  is  Anderson.  I'm  President  of  the  Bowdoin  and 
Charlottes  town  Raihoad." 

"Yep,"  said  Peters,  "I  heard  Mr.  Blevins  speak  of  you." 

"Well,"  I  said,  "  I  want  to  buy  the  Charlottestown  and  Western."  The 
old  shark  looked  at  me  a  moment,  then  said :    "  It  isn't  for  sale." 

I  said:  "Very  well,  then,  I'll  wait  until  the  receiver  has  it  for  sale." 
Thereupon  Peters  grunted  and  I  made  a  motion  to  get  out.  The  old  man 
then  said:  "Well,  suppose  it  was  for  sale,  how  much  would  you  pay  for  it? " 

I  said:    "Five  hundred  thousand  dollars." 

" Nothing  doing ! "  said  Peters.  "I've  got  over  a  million  in  it  now  and 
I  bought  it  from  the  Jordans  and  they  dropped  at  least  two  million  before." 

"Well,"  I  said,  "I'll  wait  for  the  receiver."  After  a  while  the  old  shark 
asked  me  how  much  money  I'd  got.  I  said,  I  had  a  few  thousand  dollars 
with  me,  I  could  get  forty  thousand  by  the  end  of  the  week,  and  I'd  agree 
to  pay  the  rest  in  three  months.  Then  he  said  I'd  have  to  agree  to  take 
care  of  the  debts.  I  said,  "No,  I  wouldn't  have  to  if  I  bought  it  of  the 
receiver."  Well,  that's  all  there  is  to  it.  We  signed  a  paper  and  he  took 
my  ten  thousand  dollars.  I  have  a  check  for  forty  thousand  dollars  in  my 
pocket  now  that  Grace's  father  gave  me. 

But  this  is  only  the  beginning.  Yesterday  I  went  to  Crocket,  the  larg- 
est stockholder  of  the  Bowdoin  and  Southern.  He  said  he  thought  I  could 
probably  lease  the  road  if  I'd  guarantee  the  old  bond  interest  and  pay  a  fair 
guaranteed  dividend  on  the  stock.  And  I've  just  secured  from  the  widow 
of  Jake  Halloway,  who  owns  a  third  of  the  Osterville  and  Eastern  stock, 
an  option  at  $27  a  share.  Her  lawyer  said  it  was  worth  $40.  I  said  $10  was 
a  fair  price,  so  we  agreed  on  $27.  The  lawyer  said  he  could  get  at  least  two 
thousand  shares  more  if  I  would  agree  to  give  at  least  $27  a  share.  Now, 
Johnny,  I  want  you  to  come  in  on  this.  You've  worked  for  somebody  else 
long  enough.  We  can  hit  it  off  together.  I'll  put  the  thing  through. 
Grace's  father  is  going  to  get  me  some  money  in  New  York,  and  he  prom- 
ised to  sell  any  bonds  or  stock  I'd  have.  His  bank  has  some  correspondent 
bank  in  New  York  that  buys  railroad  securities.  You  keep  on  working  for 
the  Central  until  after  the  consolidation  is  finished,  and  see  to  it  that  I  get 
a  good  contract  with  the  Central.  Then  you  come  as  Superintendent  of 
my  road.    I'll  give  you  some  stock  same  as  I  get. 

The  following  represents  in  abbreviated  form  the  operating  and  finan- 
cial statistics  regarding  the  roads  to  be  consolidated : 


410 

APPENDIX 

BOWDOIN 
AND 

Charlottestown 

Charlottestown 

AND 

Western 

BOWDOIN 
AND 

Southern 

OSTERVILLB 
AND 

Eastern 

$3,000,000 
5,500,000 

200,000 

1,310,315 

1,823,264 

1,268,144 

555,120 

52,666 

180,000 
165,000 

fi, 000, 000 

2,000,000 

117,000 

285,684 

314,119 

302,916 

11,203 

11,817 

50,000 

14,000,000 

5,000,000 

1,350,000 

1,918,711 

2,614,897 

1,613,532 

1,001,365 

61,817 

220,000 

300,000 

1    300,000 
1,000,000 
214,636 
370,437 
466,918 
364,707 
102,211 

Common  Stock 

Unfunded  Debts 

Freight  Receipts 

Total  Revenues 

Operating  Expenses. .  . 

Net  Revenues 

Taxes 

Interest  on  Bonds .... 
Dividends 

15,000 
20  000 

'  Including  back  taxes. 

Prepare  a  plan  of  consolidation,  including  the  tentative  arrangements 
that  Anderson  stated  he  had  made,  such  as  to  afford  the  basis  for  a  success- 
ful operating  railroad. 

Chapter  XX— The  Public  Utility  Holding  Company 

*7o.  The  city  of  Jefferson  in  Pennsylvania  has  a  natural  gas  company,  a 
street  railway  connecting  Jefferson  with  Whitesboro  in  one  direction  and 
Gardner  in  the  other,  an  electric  company  that  supplies  Jefferson  with 
light  and  power,  and  finally,  a  mimicipally  owned  natural  gas,  electric 
station  that  supplies  current  for  the  street  lights  and  light  and  power  to 
the  municipally  owned  water-pumping  station  and  the  public  buildings. 
There  are  also  small  electric  companies  operating  in  Whitesboro  and  Gard- 
ner. The  one  in  Whitesboro  is  owned  by  the  same  men  who  own  the  street 
railway.  The  electric  lighting  plant  in  Gardner  is  owned  by  the  munici- 
pality. 

James  M.  Jordan,  the  largest  stockholder  in  the  Jefferson  Electric 
Company  is  approached  by  Edgar  Heme,  the  owner  of  a  majority  of  the 
bonds  and  upwards  of  96%  of  the  stock  of  the  electric  railway,  who  sug- 
gests the  formation  of  a  consolidation  to  acquire  and  operate  all  the  public 
utilities  in  Jefferson,  Whitesboro,  and  Gardner,  except  the  municipally 
owned  water  supply  companies.  Heme  had  previously  secured  an  option 
on  the  municipal  lighting  and  power  plant  of  Jefferson  for  $100,000  carry- 
ing with  it  an  equable  contract  between  the  city  and  the  ptu"chasers  for 
supplying  the  city  lighting  and  power.  Heme  had  secured,  also,  an  option 
on  the  Gardner  municipal  electric  plant,  doing  both  municipal  and  com- 


PROBLEMS 


411 


mercial  business;  this  required  $25,000  in  money,  provided  the  purchasers 
will  supply  24-hour  service  in  Gardner  at  the  same  rates  as  should  be  at  any 
time  charged  in  Jefferson.  The  service  had  theretofore  been  poor  and  ex- 
pensive; the  plant  was  antiquated  and  costly  to  maintain. 

The  following  represent  the  chief  operating  and  financial  statistics: 


Jefferson 

Jefferson 

Jefferson 

Whitesboro 

Electric 

Railroad 

Gas 

Lighting 

Company 

Company 

Company 

Company 

I'inancial 

$612,000  (5%) 
400,000  (6%) 
150,000  (6%) 

$    500,000  (s%) 
300.000  (7%) 

$200,000  (5%) 

$64,000  (4H%) 

Preferred  Stock 

Common  Stock 

550,000 

1,000,000 

200,000 

100,000 

Operating — Average    for 

Five     Preceding 

Years — (even  ooo) 

Gross  Revenue 

184,000 

211,000 

165,000 

24,000 

Operating  Expense  . .  . 

Il8,000 

171.000 

120,000 

16,000 

Net  Earnings 

66,000 

40,000 

45.000 

8,000 

Bond  Interest 

24,000 

25,000 

10,000 

3.000 

Note  Interest 

6,000 

8,000 

Dividends 

20,000 

Preceding  Year 

Gross  Revenue 

216,000 

206,000 

185,000 

27,000 

Operating  Expenses. . . 

144,000 

180,000 

142,000 

23,000 

Net  Earnings 

72,000 

26,000 

43.000 

4,000 

Bond  Interest 

31.000 

25,000 

10,000 

3.000 

Note  Interest 

16,000 

21,000 

20,000 

There  were  no  accounts  kept  for  the  municipal  plant  at  Jefferson.  It 
had  cost  originally,  12  years  before,  $117,000.  No  depreciation  had  been 
charged. 

The  municipal  plant  at  Gardner  collected  $31,000  in  commercial  re- 
venue, during  the  preceding  year,  and  no  charge  was  allocated  to  the  town. 
It  cost  to  operate  $47,000. 

Heme  wanted  to  form  a  general  consolidation.  Jordan  refused,  alleg- 
ing that  a  general  consolidation  of  all  the  properties  would  destroy  the  old 
and  valuable  franchise  rights  of  the  Jefferson  Electric  Company.  This, 
however,  was  not  his  real  reason.  Finally,  Heme  consented  to  the  organ- 
ization of  a  holding  company,  to  be  incorporated  under  Delaware  laws,  to 
hold  the  stocks  of  the  operating  companies. 


412  APPENDIX 

What  was  probably  Jordan's  real  reason  for  refusing  to  co-operate  in 
the  organization  of  a  direct  consolidation?  Prepare  the  financial  plan  of 
the  holding  company,  indicate  the  equable  means  for  acquiring  the  operat- 
ing subsidiaries  and,  finally,  prepare  letters  to  go  to  the  security  holders  of 
the  Jefferson  Electric,  Jefferson  Gas,  and  Jefferson  Raih-oad  Companies 
and  the  Whitesboro  Electric  Company. 

**  71.  Edward  Blake  was  born  in  Stoughton,  Massachusetts,  in  1876. 
After  having  been  graduated  at  the  high  school,  he  entered  the  Massa- 
chusetts Institute  of  Technology,  earning  his  way  through  by  working  for 
the  local  telephone  company  and  by  the  aid  of  scholarships.  He  was  grad- 
uated second  in  his  special  study  of  electrical  engineering.  In  1900  he  went 
to  Schenectady  in  the  employ  of  the  General  Electric  Company.  In  1905 
he  became  Superintendent  of  their  small  motor  assembling  room;  in  1907 
he  left  the  employ  of  the  General  Electric  Company  to  become  Superintend- 
ent of  Construction  for  one  of  the  largest  of  the  American  Light  and  Trac- 
tion subsidiaries.  In  191 1  he  resigned  from  the  employment  of  Emerson 
Macmillan,  and  became  a  construction  engineer  with  the  American  Gas 
and  Electric  Company.  In  191 5  James  L.  Brewster  and  Company,  bank- 
ers in  Boston,  received  a  report  from  a  local  correspondent  in  Canton, 
Ohio,  that  a  young  engineer  with  a  good  record  had  secured  the  financial 
backing  of  James  Eustis,  owner  of  a  large  machine  shop,  in  his  project  to 
acquire  a  group  of  small  widely  separated  utilities  to  be  operated  under 
one  management.  Brewster  had  been  a  member  of  5  or  6  syndicates  for 
the  sale  of  holding  company  securities,  all  of  which  had  turned  out  very 
profitably.  His  firm,  lured  by  these  profits,  was  then  planning  to  organize 
a  holding  company,  but  was  at  a  loss  to  know  how  to  go  about  it. 

On  receipt  of  the  report  from  Canton,  Nathan  Miles,  the  junior  mem- 
ber of  the  partnership,  went  to  Canton,  interviewed  Blake,  and  arranged 
that  he  should  come  to  Boston  immediately  with  complete  details  of  all  the 
work  he  had  done  in  connection  with  his  projected  holding  company. 

After  investigation,  the  Brewster  firm  agreed  to  back  Blake  in  his 
undertaking,  provided  Blake  showed  that  the  properties  he  should  acquire 
warranted  financial  support  by  reason  of  their  inherent  earning  capacity 
and  the  probable  future  development  of  the  communities  they  served. 

Brewster  laid  down  the  following  principles  as  the  conditions  to  govern 
Blake  in  the  acquisition  of  the  options: 

I .  The  localities  served  must  show  substantial  increase  in  population 

from  1900  to  19 10. 
•2.  The  communities  must  be  progressive  and  public  spirited. 


PROBLEMS  413 

3.  The  franchise  situation  must  be  sound. 

4.  The  prices  to  be  paid  for  the  properties  must  include  all  the  securi- 

ties and  debts,  so  that  the  bonds  to  be  issued  upon  them  and 
sold  by  Brewster  should  be  absolute  first  liens,  that  is,  there 
should  remain  no  outstanding  underlying  liens. 

5.  The  net  earnings  of  the  properties  during  the  preceding   year 

should  be  at  least  12%  of  the  total  cash  price  to  be  paid.  And 
the  improvements  necessarily  made  during  the  first  year  should 
increase,  in  the  judgment  of  Blake,  the  net  earnings  during  the 
second  year  by  at  least  15%  of  their  cost. 

The  Brewster  firm  laid  down  no  other  imperative  conditions,  except 
that  they  recommended  that  Blake  limit  himself  to  electric  light  and 
power  properties,  and  suggested  that  no  southern  or  far  western  companies 
be  acquired  until  after  Blake  had  built  up  an  operating  organization. 

Blake  spent  the  summer  of  1913  traveling  about  the  country  investigat- 
ing electric  properties.  On  September  18,  he  reported  concerning  6  small 
companies.  The  following  represents  an  abbreviated  outline  of  his  report. 

Hudson,  Ohio.  County  seat.  About  8,100  inhabitants.  Condensed 
milk  factory.  Distributing  center  of  a  large  and  rich  agricultural  section. 
Population  shows  slight  increase.  Deposits  in  local  banks  doubled  from 
1905  to  191 2.  Local  board  of  trade  have  recently  completed  arrangements 
enabling  a  large  evaporated  milk  company  to  build  a  factory  here.  Citi- 
zens are  donating  the  site  and  exempting  company  from  local  taxation  for 
period  of  7  years.    Plant  will  employ  500  men  and  women. 

Electric  light  plant  antiquated.  Three  upright  boilers,  belt  and  shaft 
connection  with  one  100  k.  v.  a.  generator  and  two  Westinghouse  250 
k.w. — 2  200  V.  Distributing  system  good.  Customers  concentrated,  ample 
transformer  capacity,  and  large  secondary. 

Outskirts  of  town  not  served.  $16,000  should  be  spent  on  extending 
distributing  system  immediately.  Within  a  year  new  boilers  and  a  steam 
turbine  should  be  installed,  at  cost  of  at  least  $40,000. 

Marysboro,  Ohio.  Important  agricultural  center  north  of  Columbus; 
about  4,000  inhabitants.  Three  small  manufacturing  units.  A  fourth  has 
just  moved  its  plant  away  from  Marysboro  on  account  of  labor  shortage, 
poor  power  and  dissatisfaction  with  the  C.  C.  C.  and  St.  Louis  on  account 
of  1.  c.  1.  rates  on  its  finished  product.  Very  great  wealth  among  the  sur- 
rounding farmers.  Large  proportion  of  inhabitants  represent  retired  farm- 
ers who  have  "moved  to  town."  Sleepy  atmosphere;  place  requires  an 
energetic  board  of  trade. 


414  APPENDIX 

Electric  light  plant  consists  of  3  antiquated,  inefficient  upright  boilers. 
There  is  a  fourth  boiler  which  the  local  manager  called  "reserve,"  which 
might  be  fired  provided  it  was  sufficiently  "doctored  up."  One  excellent, 
belt-connected  500  k.w.  Westinghouse  generator.  One  250  G.E.  unit, 
apparently  about  6  years  old,  which  the  manager  said  had  been  bought 
second-hand.  Two  100  k.v.a.  machines,  evidently  rebuilt,  which  manager 
said  had  not  been  run  for  2  years. 

There  is  an  artificial  ice  plant  in  the  same  building.  Manager  said 
there  was  a  profitable  demand  for  at  least  twice  the  ice  capacity  of  the 
plant  during  summer.  Storage  facilities  very  limited.  Considering,  how- 
ever, the  inefficiency  of  the  boilers,  it  is  unquestionably  true  that  the  ice 
business  is  not  as  profitable  as  accounts  seemed  to  indicate.  Could  be 
made  a  profitable  business  provided  new  boilers  installed  and  the  storage 
capacity  at  least  doubled. 

Distributing  system  fair.  Business  well  developed.  Some  new  business 
could  be  secured  by  running  line  to  Petoria,  a  small  railroad  junction  point 
to  the  north. 

Only  imperative  improvement  would  be  new  boilers;  cost  about  $15,000. 

Cory,  West  Virginia.  Railroad  and  mining  center;  9,000  inhabitants. 
Town  overgrown.  Population  largely  foreign  bom,  ignorant,  receiving 
excellent  wages.  Retail  liquor  sales,  according  to  bank  report,  $165,000 
last  year.    Schools  poor;  attendance  poor. 

Company  already  distributes  electricity  to  Argentine,  across  the  river, 
and  to  4  large  coal  mines  just  back  of  Argentine. 

Company  has  a  thoroughly  modern  plant  on  bank  of  river,  to  which 
coal  is  conveyed  by  gravity,  overhead  trolley  conveyer  from  mouth  of  coal 
mine  125  yards  distant.  Very  favorable  coal  contract;  65  cents  delivered 
to  the  company's  bunkers.  Equipment  consists  of  4  horizontal  tubular 
boilers,  superheater,  one  750  k.w.  G.  E.  turbine,  installed  4  months  before, 
two  500  k.w.  Westinghouse  units  belt  driven  from  somewhat  antiquated 
steam  engine.  These  were  held  as  reserve  until  last  April,  but  now  used 
to  carry  load  during  daytime.  Company  now  installing  one  1,500  k.w. 
G.  E.  turbine.  Within  a  year  must  add  2  new  boilers  at  expense  of  at  least 
$25,000. 

Electricity  supplied  chiefly  to  coal  mines  at  2,200  v.  Load  factor  un- 
usually good.  Company  makes  little  effort  to  develop  domestic  business 
and  little  secondary. 

Summit,  Maryland.  About  14  miles  west  of  Baltimore.  Town  of 
4,000  inhabitants;  only  industry,  2  large  cotton  duck  mills  belong  to  a 
"trust"  apparently  always  in  financial  difficulties.     Labor  poorly  paid. 


PROBLEMS  415 

Mills  themselves  obtain  part  of  their  power  from  their  own  water  power 
development,  part  from  2  antiquated  steam  plants.  During  last  3  years 
have  been  buying  an  increasing  proportion  of  power  from  electric  company. 
Always  in  arrears  on  power  bills.  Twice  in  the  last  year  the  electric 
company  pulled  the  cotton  mill  switch  because  of  non-payment  of  power 
bills.  Once  filed  attachment  on  cotton  in  warehouse.  Bills  always  finally 
paid,  but  situation  annoying  and  likely  to  lead  to  trouble. 

Electric  company  has  modern  hydroelectric  development  4  miles  back 
of  town.  This  generates  all  electricity  needed  during  7  months  of  year. 
During  3  of  remaining  months  an  antiquated  steam  station  is  used  while 
the  cotton  mills  are  in  operation.  During  the  remaining  2  months  the 
steam  station  supplies  from  H  to  H  the  electricity  required  and  is  taxed 
to  the  utmost.  Company  now  negotiating  a  contract  with  the  Consoli- 
dated interests  of  Baltimore  to  enable  it  to  purchase  auxiliary  current. 
If  this  contract  is  consummated,  probably  advisable  to  scrap  the  steam  sta- 
tion. Cost  of  transmission  line,  13,000  v.,  to  the  Consolidated  substation 
$27,000.  Scrap  value  of  steam  station  probably  $8,000.  Distributing 
system  ample.    No  extensions  need  be  built  for  a  year  at  least. 

Hamilton,  New  York.  Main  line  New  York  Central,  Albany  to  Buffa- 
lo, 7,000  inhabitants.  Very  little  manufacturing,  except  local  milk  powder 
factory  and  cheese  factory.  These  inefficient  and  managed  largely  by 
farmers.  Located  in  center  of  very  prosperous  and  rich  dairying  country. 
Farmers  rich  and  not  very  progressive.  Electric  light  company  allowed  to 
go  to  seed.  Chief,  if  not  only,  stockholder  lives  in  Jamestown  and  takes 
no  interest  whatever  in  company.  Owns  and  operates  a  small  factory  for 
the  manufacture  of  mahogany  furniture;  this  has  been  a  losing  proposition 
and  has  required  all  his  time  and  attention.  Would  sell  out  the  entire 
electric  light  plant  free  from  all  debt,  provided  cash  is  forthcoming  within 
30  days.  Plant  consists  of  3  small  horizontal  boilers.  Two  utterly  unfit,  and 
insurance  will  not  be  available  after  the  first  of  year.  Plant  has  some  old 
d.  c.  generating  machinery.  On  the  whole,  plant  so  inefficient  and  badly 
located  that  would  not  pay  to  patch  up.  The  transmission  line  of  a  large 
hydroelectric  company  runs  within  30  miles.  On  the  way  are  3  small 
hamlets,  without  electric  service  and  one  town  of  1,500  inhabitants,  having 
a  locally  owned  electric  light  company  which  generates  by  a  gas  engine. 
No  option  on  this  company,  but  current  could  be  sold  to  it  at  wholesale. 
Cost  of  transmission  line,  including  right  of  way  transformers  and  sub- 
station, 192,000.  The  hydroelectric  company  will  loan  half  of  the  cost, 
provided  the  loan  is  secured  by  a  specific  lien  on  the  transmission  line. 

Distributing  system  in  town  poor.    About  $11 ,000  should  be  expended 


4l6  APPENDIX 

on  it  immediately.  About  half  the  houses  are  wired.  Few  appliances  used. 
Bank  deposits  nearly  3  times  the  average  per  capita  for  rural  New  York. 
Few  families  moving  into  the  town.  Population  shows  4%  increase  from 
1900  to  1 9 10.     Rate  less  than  that  now. 

Situsville,  Pennsylvania.  Seventy-five  hundred  inhabitants.  In  center 
of  original  oil  fields.  Served  by  branch  lines  of  the  Pennsylvania  and  New 
York  Central.  Several  oil  refineries,  2  steel  mills,  and  4  or  5  smaller  indus- 
tries. Served  by  natural  gas.  City  has  its  own  electric  station  and  owns 
and  operates  the  street  lighting. 

Plant  consists  of  series  of  gas  engines,  of  an  aggregate  of  450  k.w,  capac- 
ity. Gas  purchased  at  21  cents  per  M.  Switchboard  cost  very  low,  only 
about  .78  cents  per  k.w.h.  including  repairs  to  engines  but  without  deprecia- 
tion. Load  factor  fair.  Could  be  very  much  improved  if  company  could 
install  at  least  250  k.w.  additional  generating  capacity  and  supply  the 
largest  of  the  steel  mills,  operating  24  hours  a  day,  with  power.  Improve- 
ment would  cost  $12,000.  Steel  company  will  pay  a  flat  energy  charge  of 
1.7  cents  for  a  minimum  of  750,000  k.w.h.  for  the  first  year.  Steel  mill 
would  pay  for  its  own  line  to  the  company's  switchboard,  but  would  have 
to  be  assured  of  adequate  available  power. 

Large  number  of  domestic  customers.  Town  has  unusually  large  pro- 
portion of  wealthy  men ;  fathers  or  grandfathers  made  fortunes  at  time  of 
early  exploitation  of  oil  industry.  Second  and  third  generation  live  in 
large,  ostentatious  houses  on  hill  to  northwest  of  town.  Some  public- 
spirited  men  among  this  class,  but  majority  spend  considerable  portions 
of  year  away  and  are  inclined  to  forget  Situsville  and  oil. 

The  financial  and  operating  statistics  of  these  6  companies  are  given 
in  tabular  form  on  the  next  page. 

After  careful  consideration  James  L.  Brewster  and  Company  arranged 
to  acquire  5  of  the  properties  held  by  Blake  under  option,  but  rejected  the 
sixth  because  least  desirable.    Which  was  it  and  why? 

Prepare  a  financial  plan  for  the  Interstate  Lighting  and  Service  Com- 
pany, and  a  brief  descriptive  circular  such  as  might  be  submitted  to  inves- 
tors. 

Chapter  XXII — Financing  of  Extensions  from  the  Public 

72.  In  1892  the  Hamilton,  Morristown  and  Eastern  Railroad  issued 
$3,000,000,6%  first  mortgage  bonds,  callable  at  105  and  due  in  1942.  In 
1903  general  interest  rates  on  medium -grade  railroad  bonds  had  so  fallen 
and  the  credit  of  the  Hamilton,  Morristown  and  Eastern  Railroad  had 


PROBLEMS 


417 


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41 8  APPENDIX 

so  improved,  that  the  treasurer  found  it  possible  to  sell  long-term 
(hundred-year)  first  mortgage  4%  bonds  at  90. 

Determine  whether  or  not  it  was  expedient  for  the  treasurer  to  redeem 
the  earlier  issue  of  bonds  by  means  of  a  new  issue. 

73.  The  Consolidated  Light  and  Power  Company  was  formed  in  1 916 
as  successor,  by  consolidation,  of  three  small  electric  and  gas  companies. 
These  latter  had  outstanding  the  following  underlying  issues: 

City  Gas  Company,  first  mortgage  6's,  1928,  $438,000.  Callable  at 
105,  and  having  a  current  market  price  of  102.  Approximately  $307,000 
are  held  by  three  local  interests  who  promise  to  deliver  their  bonds  to  the 
new  company  for  103  in  money,  or  to  refund  them  into  the  new  5%  bonds, 
presently  to  be  described,  at  80  for  the  new  bonds  and  105  for  the  old  bonds. 
The  remaining  $131,000  will  probably  have  to  be  called. 

Consumers  Electric  Light  Company,  first  mortgage  5's,  1941,  $600,000. 
Callable  at  loi  and  having  a  current  market  price  of  91^^.  The  bankers 
who  originally  placed  these  bonds  stand  ready  to  acquire  and  deliver  to 
the  company  the  entire  issue  for  97K  iri  cash. 

Merchants  Electric  Light  and  Power  Company,  first  and  refunding  5's, 
a  second  mortgage  on  the  electric  central  and  distributing  system,  sub- 
ject to  the  lien  of  Consumer's  first  5's  next  above  mentioned.  Due  1945, 
$1,400,000  outstanding.  Callable  at  io2>^.  Current  market  price  84. 
The  company  has  an  option  on  $500,000  of  these  bonds  at  85  in  cash. 
There  is  every  reason  to  believe  that  at  least  two-thirds  of  the  remainder 
of  the  issue  will  be  exchanged  for  the  new  5%  bonds,  provided  the  com- 
pany offers  a  bonus  of  10%  in  the  new  bonds.  The  remainder  will  probably 
have  to  be  called. 

Bankers  stand  ready  to  buy  all  or  any  part  of  a  new  issue  of  $5,000,000, 
5%  40-year  bonds  at  82^,  provided  the  mortgage  be  drawn  so  as  to  stand 
as  a  first  lien  on  the  entire  property  of  the  gas  and  electric  light  company. 

What  is  the  maximum  amount  of  money  the  company  would  receive 
from  the  entire  issue  of  new  bonds? 

Chapter  XXni — New  Capital  from  Sales  of  Stock — Particularly  to  Stockholders 

74.  The  stock  of  the  Stuart  Manufacturing  Company  was  selling  for 
$131  a  share  at  the  time  the  total  capitalization  was  represented  by 
$3,000,000  of  common  capital  stock.  The  stock  was  doubled  in  the  spring 
of  191 7,  the  old  stockholders  having  been  given  the  privilege  of  subscribing 
to  the  new  stock  at  par. 

What  was  the  probable  value  of  the  right  adhering  to  each  old  share? 


PROBLEMS  419 

75.  The  stock  of  the  American  Telephone  and  Telegraph  Company 
was  quoted  at  145.  The  company  offered  the  holders  of  every  5  shares  the 
right  to  subscribe  to  one  new  share  at  $100  a  share. 

Granting  that  there  was  no  relative  change  in  the  market  price  of  the 
stock,  in  the  period  during  which  the  stockholders  were  privileged  to  sub- 
scribe, what  would  be  the  market  price  of  the  stock  after  the  expiration  of 
the  subscription  period? 

76.  In  March,  1922,  the  Hartford  Fire  Insurance  Company  increased 
its  capital  stock  from  $4,000,000  to  $8,000,000  by  allowing  the  old  stock- 
holders to  subscribe  to  the  new  stock  at  par,  in  proportion  to  their  holdings. 
The  rights  adhering  to  the  old  shares  had  a  current  market  quotation  of 
$230  each. 

What  was  the  value  of  a  share  of  the  company's  stock  before  the  in- 
crease in  capitalization? 

77.  At  a  certain  time  in  its  history  the  United  Fruit  Company,  the 
stock  of  which  was  then  selling  at  $188  a  share,  declared  a  cash  dividend 
of  $10  a  share.  The  stockholders  could,  however,  use  this  dividend  to  sub- 
scribe to  new  stock  at  par.  Cash  could  not  be  used  for  such  subscrip- 
tions. 

What  was  the  value  of  the  United  Fruit  Company's  stock  after  the 
payment  of  the  dividend  of  $10,  granting  that  the  general  level  of  stock 
market  prices  had  not  changed  in  the  meantime? 


Chapter  XXVI — Railroad  Reorganization 

78.  The  Eastern  Valley,  Sumpter  and  Southern  Railroad  has  outstand- 
ing the  following  securities : 

Sumpter  Division  (Main  Line),  First  Mortgage  Bonds  6% $1,000,000 

Sumpter  Division  (Main  Line),  Second  Mortgage  Bonds  5% . . . .  500,000 

First  Mortgage  Bonds  4% 4,000,000 

Debentures  5% 2,000,000 

Branch  Line  First  Mortgage  Bonds  7% 300,000 

General  Mortgage  Bonds  5% 3,000,000 

Income  Bonds  6% 1,500,000 

First  and  Refunding  Mortgage  Bonds  (open  end  issue)  5% 2,600,000 

First  Preferred  Stock  4% 6,000,000 

Second  Preferred  Stock  4% 2,000,000 

Common  Stock 10,000,000 


420  APPENDIX 

Its  operating  account  during  the  year  ending  June  30,  19 14,  was: 

Gross  Revenue  from  All  Sources $2,228,000 

Operating  Expenses,  Including  Maintenance 1,492,000 

Taxes 37,ooo 

Improvements  and  Betterment 49,000 

What  capital  payments  may  or  should  the  corporation  make? 

79.  The  Western  Mississippi  Railroad  had  outstanding  $3,000,000  prior 
lien  5%  bonds  and  $3,000,000  cumulative  income  6%  bonds.  The  latter 
were  cumulative  from  January  i,  1917.  In  1917  the  corporation  paid 
2.85%  on  the  income  bonds.  The  income  and  expense  account  for  1918 
stood  as  follows: 

Total  Operating  Revenues $1,354,748 

Maintenance  of  Ways  and  Structures 126,738 

Maintenance  of  Equipment 189,854 

Transportation 427,877 

Traffic 33,825 

General  Expenses 44>797 

Taxes 84,665 

Uncollected  Revenue 513 

Income  from  Rentals 16,271 

Interest  and  Dividend  from  Subsidiary  Companies 5.598 

Miscellaneous  Non-Operating  Receipts 1,302 

Hire  of  Equipment,  Dr 7,740 

Rentals,  Dr 14,508 

New  Construction 82,617 

Purchase  of  Ferry-boat 17,016 

Insurance 1,871 

Stokes  Hill  Cut  Off 31,612 

What  percentage,  if  any,  should  be  paid  on  the  income  bonds  for 
1918? 

*8o.  (Names,  figures,  and  places  altered.)  The  Sunboro  and  Eastern 
Pennsylvania  Railroad  passed  into  the  hands  of  receivers  on  August  10, 
1914.  The  road  had  been  suffering  from  a  combination  of  maladies  for  a 
period  of  over  7  years.  During  this  time  the  gross  earnings  had  risen 
from  $7,614,000  to  $12,143,000,  while  the  operating  expenses  had  risen 
from  $5,396,000  to  $11,134,000.  The  experience  of  these  7  years  may  be 
seen  at  a  glance  from  the  following  tables: 


PROBLEMS 


421 


Year  Ending  June  30 
(000  omitted) 


Gross  Earnings .... 

Maintenance 

Other  Operating  Ex- 
penses, including  Taxes 

Total  Operating  Ex- 
penses   

Net 

Interest  Charges .  . 

Operating  Ratio .  . 


1908 

1909 

1910 

I9II 

1912 

1913 

I7.6I4 

18. 713 

£9,112 

$11,318 

$10,792 

J11.516 

2,403 

2,617 

2,319 

2.732 

3.019 

2.991 

2.993 

3.380 

4,176 

6. SIS 

6.007 

7.166 

5,396 

5.997 

6,495 

9.247 

9,028 

10,157 

2,218 

2,716 

2,617 

2,071 

1,764 

I.3S9 

l.OIS 

r.ois 

I.OIS 

910 

970 

1,030 

71% 

69% 

72% 

82% 

84% 

88% 

I9I4 


II2.I43 
2,711 

8.423 
II. 134 

1,009 
1.030 
92% 


Issued  in  1885,  due 
Secured  by  the  same 


At  the  time  of  the  failure,  August  10,  1914,  there  were  outstanding  the 
following  funded  liabilities: 

1.  Sunboro  and  Harrisfield  first  mortgage  y's.  Issued  1880,  due  in  1910 
and  extended  at  5%  to  i960.  A  first  mortgage  on  the  main  line  extending 
between  the  two  terminals  of  the  railroad,  264  miles.  16,738,000  outstand- 
ing.   Mortgage  closed. 

2.  Sunboro  and  Harrisfield,  second  mortgage  6's. 
in  1945.  $1,816,000  outstanding.  Mortgage  closed, 
property  as  the  first  mortgage  7  's  but  junior  to  it. 

3.  Dobbinsville Division.  First6's.  Issuedini89i,dueini92i.  Afirst 
mortgage  on  the  branch  line  from  Mason  Junction  to  Hartford's,  68  miles. 
$710,000  outstanding.  Mortgage  closed.  This  branch  reaches  important 
coal  properties,  and  originates  about  69%  of  the  coal  traffic  of  the  road. 
The  total  coal  traffic  represents  about  53%  of  ton  miles  handled  by  the  road. 

4.  Sunboro  and  Eastern  Pennsylvania  Railroad  first  mortgage  5% 
gold  bonds.  Issued  in  1898  and  due  in  1938.  A  Hen  on  687  miles  of  line 
subject  to  the  two  preceding  issues  on  the  main  line  and  to  the  Dobbins- 
ville divisional  bonds.     $5,750,000  outstanding.    Mortgage  closed. 

5.  Sunboro  and  Eastern  Pennsylvania  Railroad  general  mortgage  5% 
bonds.  Secured  by  the  same  property  as  the  preceding  (first  mortgage 
5's)  but  subject  thereto.  $10,000,000  authorized,  $2,685,000  outstanding. 
Issued  in  1903  and  due  in  1953. 

6.  Debentures.    $2,000,000  6's.    Issued  in  1912,  due  in  1922. 

7.  There  were  outstanding  $1,260,000  of  4%  equipment  obligations 
The  amount  was  originally  $1,800,000  issued  in  191 1  to  purchase  approxi- 


422  APPENDIX 

mately  $2,000,000  of  steel  coal  cars.  The  contract,  issued  under  the  Phila- 
delphia plan,  with  the  Ferrard  Trust  Company,  owner  and  lessor,  called  for 
annual  instalment  payments  of  $180,000.  These  had  been  met  regularly. 
The  interest  on  the  outstanding  certificates  had  been  regularly  charged  to 
operatin;"^  expenses. 

In  addition  the  company  had  the  following  obligations  outstanding: 

Merchandise  debts  contracted  before  February  10,  1914,  $773,000. 

Current  merchandise  debts  contracted  since  February  10,  19 14, 
$216,000. 

Current  pay-roll,  salary  and  other  labor  charges,  $69,000. 

Bank  loans  maturing  before  September  i,  1914,  $100,000. 

Bank  loans  maturing  before  January  i,  1915,  $60,000. 

Bank  loans  maturing  after  January  i,  191 5,  none. 

The  stock  issues  were  represented  by  $5,000,000  6%  non-cumulative 
preferred  and  $5,000,000  common  stock. 

On  August  25, 1914,  the  receiver  obtained  permission  to  issue  $500,000 
par  value  2-year  6%  receivers'  certificates,  ranking,  prior  to  the  Sunboro 
and  Eastern  Pennsylvania  general  mortgage  bonds.  These  were  sold  for 
98  to  banks  and  the  proceeds  used  to  pay  the  current  merchandise  bills  of 
$2 16,000  and  the  unpaid  pay-roll  of  $69,000.  The  remainder  was  expended 
in  the  next  8  months  in  repairs,  betterments,  and  general  improvements. 

Another  issue  of  $180,000  was  made  in  February,  191 5,  in  order  to 
meet  the  annual  instalment  on  the  equipment  trust  obligations. 

The  receivers'  report  for  year  ending  June,  191 5,  showed  the  following: 

Gross  Earnings $1 1,978,000 

Maintenance 5,1 12,000 

Other  Operating  Expenses  Including  Taxes 6,224,000 

Net  Earnings 642,000 

The  receiver  admitted  in  his  report  to  the  general  reorganization  com- 
mittee that  at  least  35%  of  the  maintenance  charges  were  extraordinary 
due  to  the  previous  protracted  period  of  under-maintenance. 

It  was  also  clear  that  the  falling  off  of  gross  earnings  was  due  to  the 
depression  consequent  upon  the  Great  War.  During  the  6  months  of  the 
vear  from  June  30  to  December  31,  1914,  the  gross  earnings  had  been  ap- 
proximately $4,800,000,  in  comparison  with  approximately  $7,100,000  for 
the  last  6  months  of  the  fiscal  year.  The  receiver  reported  that,  because  of 
previous  liberal  charges  to  maintenance,  he  was  able  to  show  a  net  operat- 
ing ratio  for  the  4  months  from  May  i,  1915  to  August  31,  1915  of  7% 
below  that  of  the  fiscal  year  ending  June  30,  1914. 


PROBLEMS 


423 


In  September,  1915,  the  General  Reorganization  Committee  prepared 
a  plan  of  reorganization.     What  plan  would  you  suggest? 


GENERAL  COMMENT  AND  SOLUTION 

Past  History 

From  an  inspection  of  the  earnings  and  statements  of  the  Sunboro  and 
Eastern  Pennsylvania  Railroad  from  1908  to  19 14  three  things  are  obvious: 

1.  The  road  has  not  obtained  a  normal  increase  in  gross  earnings. 
The  year  ending  June  30,  1908  was  a  year  of  depressed  railroad  earnings 
following  the  monetary  panic  of  the  autumn  of  1907.  The  steady  increase 
in  gross  earnings  from  1908  through  191 1  is  therefore  readily  understand- 
able, perfectly  normal,  and  not  indicative  of  either  remarkable  prosperity 
or  able  management.  But  from  191 1  through  19 14  the  gross  earnings  were 
stationary.  The  railroad,  operating  in  the  thickly  settled  sections  of  the 
eastern  states,  should  have  shown  a  steady  and  uninterrupted  increase  in 
gross  earnings.  The  fair  presumption,  therefore,  is  that  the  road,  by 
reason  of  inefficient  management,  was  losing  business  to  its  competitors. 

2.  The  total  operating  expenses  and  operating  ratio  have  both  in- 
creased relatively  and  absolutely.  In  1908  the  total  operating  expenses 
were  $5,400,000  out  of  a  total  gross  of  $7,600,000,  or  a  ratio  of  71%.  This 
ratio  remained  relatively  constant  for  the  next  3  years;  it  then  rose  stead- 
ily so  that  in  1914  the  total  operating  expenses  absorbed  92%  of  the  total 
gross  earnings.  Obviously  the  increase  in  cost  of  operation  was  all  out  of 
proportion  to  the  increase  in  gross  earnings.  Should  the  same  relative 
increases  continue,  the  costs  of  operation  would  presently  exceed  the  total 
receipts  of  the  road. 

3.  Although  the  total  operating  expenses  have  increased  relatively  and 
absolutely,  the  maintenance  component  of  the  operating  expenses  has 
decreased.    This  is  easily  observable  from  a  few  comparisons. 


1908 

1911 

1914 

Total  Gross 

$7,614,000 
2,403,000 
5,396,000 

32% 

45% 

$11,318,000 
2,732,000 
9,247,000 

24% 

30% 

$12,143,000 

Total  Maintenance 

2,711,000 

Total  Operating  Expenses 

11,134,000 

Percentage  of  Maintenance  to  Gross 
Percentage  of  Maintenance  to  Total 
OperatingExpenses 

22% 
25% 

424  APPENDIX 

Clearly,  and  without  question,  the  management  had  been  spending 
much  less  comparatively  in  the  up-keep  of  the  road.  Had  the  same  rela- 
tive proportion  of  gross  earnings  been  expended  in  19 14  for  maintenance  as 
in  1908,  the  1914  maintenance  charges  would  have  been  over  $3,880,000 
and  the  total  operating  costs  would  have  exceeded  the  gross  earnings. 

The  Basis  of  the  Reorganization 

Clearly  then  the  reorganization  must  be  a  drastic  one.  It  must  provide 
at  least  $680,000  in  money  with  which  to  payoff  the  receivers'  certificates 
and  should  provide,  in  addition,  some  money  to  improve  further  the  physi- 
cal condition  of  the  road.  It  would  be  well,  also,  to  secure  the  money 
requisite  to  meet  the  instalment  due  in  February,  19 16,  on  the  equipment 
certificates.  Some,  at  least,  of  the  expenses  of  the  reorganization  would 
have  to  be  met  in  money.    Altogether  $1,000,000  should  be  secured. 

The  second  requisite  of  any  reorganization  plan  would  be  a  reduction 
in  the  fixed  charges.  According  to  the  statements  of  the  company  the 
railroad  had  succeeded  in  earning  its  fixed  charges  during  all  the  years 
except  the  one  immediately  preceding  the  receivership.  Yet,  by  analyzing 
the  decrease — absolute  and  relative — of  the  maintenance  charges,  it  is 
obvious  that  this  apparent  solvency  was  due  to  marked  failure  to  maintain 
adequately  the  physical  condition  of  the  road. 

During  the  year  of  receivership,  when  the  charges  to  maintenance  were 
clearly  and  admittedly  overliberal,  the  purpose  of  the  receivership  being 
to  make  up  for  the  delinquencies  of  the  past,  the  road  showed  net  earnings 
of  $640,000.  The  interest  charges  on  the  two  underlying  main  line  bond 
issues  required  $445,860.  It  is  obvious  therefore  that  these  two  issues  can- 
not be  disturbed,  or  if  they  are  disturbed  new  securities  equal  in  value  and 
attractiveness  must  be  given  to  the  old  holders.  The  balance  of  earnings 
over  these  underlying  charges  is  about  $200,000.  The  interest  on  the 
Dobbins ville  branch  bonds  amounts  to  $42,600.  This  branch  is  very  im- 
portant to  the  present  organization  of  the  Sunboro  and  Eastern  Pennsyl- 
vania Railroad.  The  operating  and  financial  structure  of  the  road  had 
been,  during  the  preceding  4  or  5  years,  recast  so  as  to  accommodate  a 
large  coal  traffic.  A  very  large  proportion  of  this  traffic  originated  on  the 
Dobbinsville  branch.  It  would  be,  therefore,  a  very  serious  mistake  to 
jeopardize  the  ownership  or  control  of  this  branch  as  a  result  of  an  attempt 
to  disturb  the  small  issue  of  $710,000  first  mortgage  bonds,  with  interest 
charges  of  only  $42,600. 

The  two  underlying  main  line,  and  the  Dobbinsville  branch  bonds 


PROBLEMS  425 

absorb  $488,460  of  the  $642,000  available  earnings.  This  would  leave 
earnings  of  only  about  $153,000  with  which  to  meet  the  interest  on  the 
Sunboro  and  Eastern  first  mortgage  5's.  This  interest  amotmted  to  $287,- 
500.  On  this  showing  it  is  obvious  that  all  the  junior  mortgage  and  de- 
benture bondholders  must  be  prepared  to  endure  some  sacrifice,  both  in 
lien  on  income  and  on  the  "corpus"  or  property  of  the  road. 

Furthermore,  the  money  required  by  the  reorganization,  $1,000,000  in 
cash,  must  be  obtained  from  the  junior  security  holders,  presumably  the 
stockholders.  So  that  the  crux  of  the  problem  of  the  reorganization  be- 
comes a  kind  of  "give  and  take"  between  the  junior  bondholders  and  the 
stockholders. 

The  Plan 

One  of  two  plans  might  be  adopted.  Either  all  the  seciu-ity  holders, 
including  the  owners  of  the  underlying  bonds,  might  agree  to  a  thorough 
and  comprehensive  reorganization  in  which  an  entirely  new  and  much 
simplified  financial  structure  would  be  created  out  of  the  old  one,  or  the 
holders  of  junior  securities  might  decide  upon  a  reorganization  in  which 
only  the  junior  securities  would  be  disturbed,  the  underlying  bonds  to 
remain  as  they  are.  The  former  alternative  would  require  the  consent  and 
active  co-operation  of  the  senior  bondholders — and  therefore  would  be 
more  difficult  to  execute — but  it  would  at  the  same  time  produce  a  more 
permanent  and  stable  financial  structure.  The  second  alternative  would 
be  quicker,  easier,  and  less  expensive  to  execute;  it  would,  however,  merely 
ameliorate  the  present  distress  without  effecting  a  thorough  and  abiding 
cure.  The  decision  would,  in  the  end,  rest  with  the  senior  bondholders. 
If  they  were  well  organized  and  showed  a  wiUingness  to  co-operate,  it 
would  be  wise  financial  policy  to  effect  a  general  reorganization  involving 
the  refunding  of  all  the  sectu-ities;  if  they  were  scattered,  unorganized,  and 
showed  little  interest  in  the  fortunes  of  the  road,  it  would  be  foolish  to  do 
more  than  fund  the  current  debt  and  reduce  the  charges  on  the  junior  bonds. 

We  will  assume,  for  purposes  of  argtunent  and  discussion,  that  the 
active  co-operation  of  the  senior  bondholders  can  be  gained  and  that  all 
parties  concerned  desire  a  comprehensive  reorganization.  To  this  end,  the 
following  securities  are  created : 

I.  First  mortgage  5%  bonds,  a  first  and  only  lien  on  the  entire  mileage 
and  equipment  of  the  Sunboro  and  Eastern  Pennsylvania  Railway,  sub- 
ject only  to  the  lien  of  the  equipment  certificates  on  certain  of  the  rolling 
stock.  Due  in  i960.  Authorized  $20,000,000.  Issued  $11,564,000.  The 
unauthorized  balance  to  be  issued  only  for  the  actual  cash  cost  of  improve- 


426  APPENDIX 

ments  and  then  only  when  the  net  earnings  are  twice  the  interest  charges 
on  the  entire  outstanding  first  mortgage  bonds,  issued  and  to  be  issued. 

2,  Preferred  stock  6%  non-cumulative.  Protected  by  a  provision  which 
prevents  the  further  issue  of  preferred  stock  without  the  consent  of  75% 
of  the  outstanding  preferred  stock.    Authorized  and  issued  $10,797,900. 

3.  Common  stock.  Authorized  and  issued  $10,846,500.  Exchange  of 
the  old  securities  into  the  new  securities.  Basis  as  indicated  in  the  table; 

Discussion  of  Plan 

It  has  been  said  already  that  the  2  underlying  mortgage  liens  of  the 
Sunboro  and  Harrisfield  must  be  fully  protected.  In  the  plan  just  out- 
lined the  two  bond  issues  are  given  the  same  consideration.  This  is  just. 
The  5's  represent  a  closed  prior  lien  on  the  whole  property.  They  are 
given  a  bonus  of  10%  in  the  new  preferred  stock  as  an  inducement  to  ac- 
cept bonds  issued  under  a  new  open  general  mortgage  covering  the  entire 
property.  The  new  bonds  will  be  more  easily  marketable  than  the  old 
bonds,  but  not  as  secure.  The  fixed  interest  return  will  be  the  same,  but  in 
addition — through  the  bonus  of  preferred  stock — the  holders  are  given  an 
opportunity  to  share  in  the  future  prosperity  of  the  road.  If  the  road  con- 
tinues a  failure  the  new  bonds  will  not,  probably,  command  a  market 
below  the  old  bonds ;  if  it  is  a  success  the  market  value  of  the  new  bonds  to- 
gether with  the  preferred  stock  bonus  will  be  greater  than  that  of  the  old 
bonds.  The  holders  will  have,  therefore,  something  to  gain,  and  nothing 
to  lose  by  the  exchange. 

The  same  policy  is  pursued  regarding  the  second  mortgage  6*s.  They 
represent  a  small  second  closed  lien  on  the  main  line,  so  that  their  security 
is  a  little  less — but  only  a  little  less — than  the  first  mortgage  5's.  The 
slightly  less  security  is  fully  compensated  for  by  the  i  per  cent  greater 
income  return.  For  purposes  of  exchange  therefore  the  two  issues  are 
regarded  as  of  the  same  intrinsic  value. 

The  Dobbinsville  branch  bonds  occupy  a  very  strong  strategic  position 
in  the  whole  financial  structure.  As  organized,  the  loss  of  the  branch  would 
do  great  injury  to  the  road;  and  the  bondholders,  were  they  allowed  to 
foreclose  and  take  the  property  for  themselves,  could  easily  make  a  satis- 
factory operating  or  traffic  agreement  with  some  other  road,  owing  to  the 
large  volume  of  coal  tonnage  which  originates  on  their  line.  On  the  other 
hand  the  bonds  represent  a  small,  practically  unmarketable  issue.  Under 
any  circumstances  they  would  be  poor  collateral  at  the  banks.  They  ma- 
ture in  5  years,  so  that  the  holder,  in  exchanging  them  for  new  5%  bonds 


PROBLEMS 


427 


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428  APPENDIX 

would  lose  at  most  i%  a  year  or  5%  in  all.  Considering  that  the  security 
of  the  new  first  5's,  covering  the  entire  road,  is  equal  to  that  of  these  branch 
line  bonds,  while  the  former  have  greater  marketability,  we  may  properly 
assume  that  a  bonus  of  10%  of  new  common  stock  fully  compensates  for  a 
loss  of  1%  in  income  for  a  period  of  five  years. 

By  reference  to  the  earnings  of  the  road  under  the  receiver  it  is  obvious 
that  interest  charges  on  the  $5,750,000  Sunboro  and  Eastern  first  s's  were 
not  earned.  (Earnings  available  after  charges  on  the  underlying  bond 
issues  [even  000],  $153,000,  interest  on  the  first  5's,  $287,500.)  Yet  the 
receiver  admits  that  35%  of  the  maintenance  charges,  or  $1,789,000,  were 
abnormal.  If  even  a  small  proportion  of  these  maintenance  charges  had 
been  capitaUzed  the  interest  of  the  Sunboro  and  Eastern  first  5's  would 
have  been  fully  earned.  Reasonable  precaution  dictates,  therefore,  that 
part  of  the  charges  on  this  issue  shall  be  made  contingent,  yet  the  bond- 
holders would  feel,  justly  perhaps,  that  they  should  not  be  called  upon  to 
make  any  real  sacrifice.  This  predicament  would  be  settled  by  giving  these 
bondholders  new  bonds  carrying  fixed  charges  of  $115,000  (40%  of  new 
first  5's  or  $20  for  each  $1000  old  bond,  2%)  or  nearly  the  balance  of  earn- 
ings available  under  the  receiver's  earning  statement,  together  with  a  very 
liberal  bonus  of  new  preferred  stock.  They  would,  therefore,  be  in  a  posi- 
tion to  receive  the  full  available  earnings  if  the  road  made  no  improvement, 
but  if  the  earnings  were  liberal  they  would  receive  an  additional  contingent 
income  of  $276,000  (80%  of  new  preferred  stock  or  $48  for  each  $1 ,000  old 
bond — 4.8%) .   This,  with  the  fixed  income,  would  give  them  6.8%  instead 

of5%- 

In  other  words,  they  endure  a  reduction  in  fixed  income,  but  are 
compensated  by  an  increase  in  fixed  and  contingent  income. 

The  efforts  to  meet  the  interest  charges  on  the  general  mortgage  5's  and 
the  debentures  precipitated  the  failure.  The  only  way  of  safeguarding  the 
reorganized  road  from  a  recurrence  of  the  same  misfortune  is  to  eliminate 
entirely  these  fixed  charges.  This  must  be  done,  whatever  else  is  accom- 
plished by  the  reorganization.  But  obviously  the  general  mortgage  bonds 
are  in  a  stronger  position  than  the  debentures — hence  the  former  are  given 
part  preferred  stock,  and  part  common,  while  the  latter  are  given  only 
common  stock.  The  unfunded  debt,  both  the  merchandise  and  the  bank 
loans,  are  considered  on  the  same  level  as  the  debentures. 

It  is  necessary  to  raise  $1,000,000.  The  preferred  stockholders  cannot 
be  relied  upon  to  come  to  the  rescue  of  the  failed  road  any  more  or  any 
less  than  the  common  shareholders.  The  burden  of  raising  the  new  money 
is  therefore  distributed  evenly  among  all  the  stockholders.    The  preferred 


PROBLEMS 


429 


stockholders,  in  deference  to  their  position,  are  given  new  preferred  stock 
for  part  of  their  old  preferred,  whereas  the  common  shareholders  are  given 
new  preferred  only  for  the  par  value  of  their  assessment. 

A  comparison  of  the  old  and  the  new  corporation  is  seen  from  the  fol- 
lowing table: 


Total  Capitalization  Including  Unfunded 
Debt,  but  not  Undisturbed  Equipment 
Obligations 

Fixed  Charge  Securities 

Fixed  Charges  not  Counting  Unfunded 
Debt 

Fixed  and  Contingent  Charges 


Old 
Company 

New 
Corporation 

$30,632,000 
19,699,000 

1,030,210 
1,330,210 

$33,208,400 
1 1 ,564,000 

578,200 
1,226,074 

It  is  obvious  from  this  table  that  the  reorganization  has  accomplished 
a  distinct  reduction  in  the  fixed  charges ;  in  fact  the  fixed  charges  are  below 
the  earnings  during  the  poorest  period  of  the  receivership,  when  the  busi- 
ness was  suffering  from  a  general  depression  and  when  the  receiver  had, 
admittedly,  increased  the  normal  maintenance  by  over  $1,000,000.  The 
fixed  charges  were,  in  fact,  only  a  little  over  half  the  net  earnings  of  the 
year  just  prior  to  the  failure.  In  addition  to  a  reduction  in  fixed  charges 
the  reorganization  had  brought  about  a  distinct  simplification  of  the  finan- 
cial structure,  and  had  secured  a  permanent  cancellation  of  the  floating 
debt  and  a  considerable  contribution  of  new  money. 

Alternative  Plan 


A  part,  at  least,  of  the  refunding  operations  of  this  plan  depends  upon 
the  willingness  of  the  holders  of  the  underlying  bonds  to  exchange  them  for 
new  bonds.  If  these  holders  refuse  to  co-operate,  or  if  they  exact  too  high 
an  inducement,  the  plan  would  have  to  be  consummated  without  their 
help.  In  that  case  the  3  underlying  issues  need  not  be  disturbed.  Such  a 
plan  would  not  bring  about  so  great  a  simplification  in  financial  structure, 
but  there  would  be  nearly  as  great  a  reduction  in  fixed  charges.  At  all 
events  the  first  mortgage  bonds  of  the  Sunboro  and  Eastern  and  all  bonds 
and  unfunded  debt  below  these  should  be  changed  from  a  fixed  to  a  con- 


430  APPENDIX 

tingent  charge  security.  In  actual  practice  this  would  be  accomplished 
through  a  foreclosure  of  the  Sunboro  and  Eastern  first  mortgage  5's,  which 
would  extinguish  the  general  mortgage  bonds  and  all  junior  securities. 

81.  On  June  30,  1902,  the  Jamestown,  East  Coast  and  Southern 
Railway  had  main  line  of  road  as  follows: 

Jamestown  to  Dobson 219.3  miles 

Huron  Branch:  Norwalk  Junction  to  Huron. . .  .        12.4 
Warrenton  Branch:  Warrenton  to  Jeflf arson.  .  .  .        13.5 

Total  Length  of  Line 245.2  miles 

History:  The  road  was  organized  July  10,  1886,  as  a  reorganization 
and  consolidation  of  the  old  Jamestown  and  Southern  and  East  Coast 
Railway.    The  Warrenton  Branch  was  built  in  1887,  the  Huron  in  1889. 

Rolling  Stock:  As  of  June  30,  1902.  Locomotive  engines,  61.  Cars, 
passenger,  18.  Combination,  6.  Baggage  and  mail,  3.  Freight  (box  900, 
platform,  165;  stock,  10;  coal,  3,964;  caboose,  35),  total  5,074;  service  cars, 
7 — total  cars,  5,108. 

Central  Division  Bonds  are  secured  by  the  main  line  from  Jamestown 
to  Dobson.  The  Eastern  Division  bonds  are  secured  by  a  cut-off  on  the 
main  line  from  Jamestown  Center  through  to  Rickers. 

The  first  mortgage  and  extension  improvement  5%  mortgage  bonds  are 
a  second  mortgage  on  the  Central  and  Eastern  Division  and  the  first  mort- 
gage on  the  Huron  Branch. 

The  third  mortgage  consolidated  bonds  are  a  third  mortgage  on  the 
Eastern  Central  Division,  second  mortgage  on  the  Huron  Branch,  and  a 
first  mortgage  on  the  Warrenton  Branch.  They  are  also  sectu-ed  by  the 
deposit  with  the  trustee  of  certain  very  valuable  traffic  agreements  cover- 
ing interchange  of  traffic  at  Jamestown  and  Dobson. 

Down  to  1899,  the  road  made  relatively  few  advances  and  improve- 
ments, the  capitalization  remaining  essentially  the  same.  In  1899  it  em- 
barked on  a  series  of  extensions,  improvements  and  financial  operations. 
These  involved  reduction  of  expensive  grades  and  curves  and  the  building 
of  a  network  of  small  branch  lines,  leading  into  coal  mines.  Until  1899  the 
road  had  carried  a  large  proportion  of  through  freight,  particularly  coal 
delivered  to  it  by  connecting  roads.  Beginning  with  1899  it  attempted  to 
develop  certain  large  areas  of  coal  lands,  lying  adjacent  to  its  main  lines. 

The  $2,000,000  of  consolidated  mortgage  bonds  were  issued  very 
largely  to  pay  for  these  improvements.  Two  years  before,  the  road  had 
acquired  an  option  on  a  large  semi-developed  coal  property  located  at 


PROBLEMS 


431 


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PROBLEMS  433 

Spencer  about  12  miles  off  from  its  main  line.  The  purpose  had  been  to 
finish  the  development  of  this  property  and  to  secure  from  it  a  large  coal 
traffic.  The  $3,000,000  lo-year  coupon  notes  had  been  issued  and  sold, 
and  the  proceeds  devoted  very  largely  to  the  purchase  of  this  coal  property. 
The  stock  of  the  coal  mine  had  been  pledged  as  collateral  for  the  lo-year 
coupon  notes.     For  financial  details  sec  tables  on  pages  431  and  432. 

On  the  publication  of  the  unfavorable  statement  of  June  30,  1902,  a 
committee  of  bankers,  consisting  of  the  trustees  of  the  Central  Division 
bonds,  the  agent  of  a  large  insurance  company  which  owned  $250,000  of 
the  Eastern  Division  bonds,  and  the  vice-president  of  a  bank  to  whom  the 
company  owed  $100,000  of  the  $405,321  bills  payable,  met  and  petitioned 
the  court  for  the  appointment  of  a  receiver.  The  president  of  the  road  and 
certain  directors  opposed  the  petition,  but  the  prayer  was  granted  by  the 
court.  A  committee  of  the  directors  was  immediately  organized  and  pro- 
posed within  30  days  a  plan  of  reorganization. 

Consider  yourself  one  of  these  directors,  what  plan  would  you  propose? 

82.  The  Portland  and  Danbury  Railroad  had  been  established  40  years 
ago.  It  had  never  been  thoroughly  successful  and  during  the  last  few  years, 
owing  partly  to  antiquated  management  and  partly  to  the  fact  that  the 
timber  tributary  to  its  lines  had  all  been  cut  away,  the  railroad  had  fared 
ill.  There  follows  a  brief  summary  of  its  condition  at  the  end  of  191 1. 
The  company  passed  into  the  hands  of  receivers  in  the  early  part  of  July 
on  a  non-resident  creditor's  bill.  At  the  time  in  question  $287,965.30  of 
the  current  liabilities  had  been  contracted  within  six  months  of  receiver- 
ship ;  practically  all  for  materials  and  supplies  necessary  for  the  continued 
operation  of  the  road.  About  a  quarter  of  the  common  stock  was  held  by 
farmers  and  small  tradesmen  living  along  the  line.  About  half  of  the  stock 
was  then  held  by  banking  interests  who  had  exercised  a  nominal  control 
over  the  railroad  from  1903  to  191 1.  The  remaining  quarter  of  the  com- 
mon stock  had  been  purchased  from  time  to  tune  by  outside  interests 
widely  scattered.  The  bankers  who  held  half  the  common  stock  were 
financially  embarrassed  and  had  pledged  the  stock  as  collateral  for  a  loan 
of  $60,000  at  a  New  York  bank. 

Prepare  a  plan  of  reorganization  of  the  road. 

The  Portland  and  Danbury  Railroad  Company 

Main  Line  of  Road 

Portland  to  Danbury 203.5  miles 

Jones  River  Division:  Jones  River  Junction  to  Cleveland.  ...        51.0     " 


434 


APPENDIX 


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PROBLEMS 


435 


Sherman's  Hill  Branch:  Sherman's  Hill  to  Winchester 

Other  Branches:  Buffalo  Springs,  4;  Hitchcock's  Mill,  6;  Bea- 
mon's,  3 ;  Savidge's,  5 


ii.o  miles 


18.0 


Total  Length  of  all  Lines  Operated 283.5  miles 

3rd  rail,  4m.;  Sidings,  21  m.; Gauge,  4  ft.  8y^  in.  and  3  ft.  Rail  (steel),  35 
and  56  lbs. 

Rolling  stock.  Locomotive  engines,  30.  Cars :  passenger,  29;  baggage, 
mail  and  express,  3;  freight  (bo.x,  2 50; platform,  429;  coal,  3),  682;  caboose, 
6;  logging,  50.  Total  cars,  770.  Of  this  equipment,  20  locomotives,  22 
passenger,  2  baggage,  etc.,  235  box,  360  platform,  6  caboose,  and  60  logging 
cars  were  acquired  through  a  car  trust. 

Operations  for  year  ending  June  30,  191 1.  Train  mileage:  passenger, 
302,312;  freight,  267,152; other,  291,062.  Total,  860,526 miles.  Passengers 
carried,  178,845;  carried  one  mile,  3,226,109;  average  mile  rate,  2.83 
cents.  Tons  freight  moved,  368,768;  moved  one  mile,  18,495,653;  average 
ton-mile  rate,  1.95  cents. 


Earnings 

Passenger $  91.349-35 

Freight 360,201.48 

Mail  and  Express.  . .  24,098.23 

Miscellaneous 22,613.98 


Total    ($1,757-54 

per  mile) 

Loss  from  Operation . 


,263.04 
39.047-37 


Expenses 

Transportation $254,776.05 

Maintenance    of 

Equipment 103,338.52 

Maintenance  of  Way 

and  Buildings.  .  .  .  128,284.93 

General 50,910.91 

Total  ($1,895.28 
per  mile) $537.3io.4i 


Financial  Statement,  June  30, 191 1.  Capital  stock  (par  $100),  $5,754,- 
890;  funded  debt  (ist  mortgage  gold  6%  30-year  $1,000  coupon  bonds,  due 
October  i,  1917,  interest  April  and  October),  $4,952,000;  equipment  trust 
obligations,  $313,960.23;  current  liabilities,  $627,172.40.  Total  liabilities, 
$11,648,022.63.  Detailed  statement  of  equipment  trust  obligations,  as  of 
June  30,  191 1,  appears  on  page  434. 

**83.  The  Tifton  Falls  Power  Company  distributes  electricity  to  power 
and  lighting  customers  in  Tifton,  a  city  of  9,500  inhabitants.  It  also  sells 
in  1919  electricity  at  1.4  cents  per  k.w.h.  (without  demand  or  coal  clauses) 
to  six  other  electric  distributing  companies  serving  as  many  communities, 
all  located  within  18  miles  of  Tifton  and  all  connected  with  the  central 
power-house  by  33,000  v.  transmission  lines.     The  company  began  to 


436 


APPENDIX 


deliver  some  current  January  i,  191 2. 
ings  for  the  next  7  years  (even  000) : 


The  following  represent  the  earn- 


1912 

1913 

1914 

19:5 

1916 

1917 

1918 

5l2,0G0 
0 

3,000 

(def.) 

$32,000 

15,000 

21,000 

$54,000 

37,000 
49.000 

$63 ,00c 

59,000 
71,000 

$  76,000 

102,000 
107,000 

$83,000 

165,000 
149,000 

I94.000 
213,000 

Gross  Sales  to  Other  Distribut- 

Net     

161,000 

During  all  of  1918  and  during  the  last  8  months  of  1917  the  power 
company  had  utilized  every  bit  of  its  hydraulic  energy,  notwithstanding 
improvements  in  its  wheels  and  generating  machinery.  In  1918  the  com- 
pany sold  about  2,000,000  k.w.h.  to  its  own  customers  at  Tifton  and  about 
15,000,000  k.w.h.  to  the  six  distributing  companies.  Of  this  17,000,000 
k.w.h.  about  12,000,000  was  generated  by  hydraulic  energy  and  the  re- 
mainder by  three  steam  stations.  Energy  at  the  steam  switchboards  was 
costing  the  company  about  1.5  cents  at  the  end  of  1 918. 

From  May  3  to  May  21,  1919,  there  was  continuous  rainfall  over  the 
storage  areas  of  the  Tifton  Falls  Power  Company.  At  6  o'clock  on  the 
evening  of  May  19  a  storage  dam  9  miles  above  the  falls  broke  away.  The 
water  began  to  rise  within  an  hour,  and  the  power  company's  dam  went 
out  in  the  early  morning.  About  8  square  miles  of  farm  land  was  inun- 
dated before  the  flood  finally  subsided. 

At  the  time  of  the  catastrophe  the  capitalization  of  the  Tifton  Falls 
Power  Company  was  as  follows: 

5%  Bonds  due  1942 $1,000,000 

Preferred  Stock  7%  cumulative  (dividends  had 

been  regularly  paid) 600,000 

Common  Stock 3,000,000 

The  company  passed  into  the  hands  of  receivers  May  25,  19 19.  On 
July  9,  1919,  representatives  of  the  six  distributing  companies,  whose 
only  available  source  of  power  had  been  the  Tifton  Falls  Power  Company, 
offered  to  sell  the  property  of  the  six  companies  to  interests  previously 
owning  63%  of  the  common  stock  for  the  actual  capital  cost  of  the  pro- 
perties— in  the  aggregate  $1,316,000.  The  owners  of  these  six  properties 
will  consent  to  take  6%  bonds — secured  by  a  first  mortgage  on  the  trans- 
mission lines  and  distributing  systems  of  these  six  companies — as  payment 


PROBLEMS  437 

for  50%  of  the  purchase  price.  The  remainder  of  the  purchase  price  must 
be  paid  in  cash. 

Consider  fully  the  entire  situation.  Granting:  (i)  that  the  aggregate 
gross  receipts  per  k.w.h.  is  the  same  in  the  six  communities  as  in  Tifton; 
(2)  that  $317,000  must  be  spent,  provided  the  dam  is  to  be  replaced 
exactly  as  before,  or  $468,000  if  the  k.w.h.  annual  output  is  to  be  increased 
by  40% — the  ultimate  limit  available  from  the  average  annual  second  feet 
of  the  Tifton  River  at  the  falls;  (3)  that  the  operating  ratio  of  the  total 
aggregate  properties  can  be  improved  by  5%  over  that  of  the  Tifton  Power 
Company  in  191 8. 

Prepare  a  general  plan  embodying  the  formation  of  a  new  company 
to  operate  the  properties  previously  owned  by  the  Tifton  Falls  Power 
Company  and  the  six  other  distributing  companies.  Your  plan  should 
contain  suggestions  as  to  procedure  after  July  9,  1919,  the  detailed  finan- 
cial plan  of  the  new  company,  and  explicit  statements  of  the  sources  of 
new  money.  You  may  assume  that  the  plans  are  to  be  consummated 
during  December,  1919. 

84.  Inigii,  Thomas  S .  Sargent  and  Company ,  Engineers ,  organized  the 
Northern  Counties  Light,  Heat  and  Power  Company.  It  represented  in 
1920,  a  holding  company  owning  only  the  common  stocks  of  9  small  elec- 
tric light  and  gas  companies  operating  in  the  towns  and  cities  of  northern 
Kansas.  From  1 9 1 2  to  the  summer  of  1 9 1 4,  the  holding  company  had  paid 
dividends  regularly  on  its  preferred  stock.  The  preferred  stock  dividend 
due  August  15,  1914,  was  passed,  the  international  turmoil  being  advanced 
as  the  excuse.  Dividends  were  not  resumed,  although  the  reports  sent  to 
the  stockholders  at  the  end  of  each  year  were  very  reassuring. 

The  company  defaulted  the  March  i,  192 1,  interest  on  its  collateral 
trust,  pi'ior  lien  5%  bonds.  No  reasons  were  alleged,  other  than  the  general 
financial  depression.  Auditors  appointed  by  a  committee  representing 
investors  mildly  hostile  to  the  interests  of  the  Sargent  firm  made  an  ex- 
haustive report.  The  main  features  of  this  report  brought  out  the  simple 
fact  that  the  extensions  and  improvements  undertaken  by  the  operating 
companies  failed  to  prove  as  profitable  as  the  engineers  had  anticipated. 
Operating  expenses  increased,  relatively  and  absolutely,  faster  than  gross 
earnings.  The  costs  of  the  extensions  of  the  operating  companies  were  met 
at  first  by  the  sale  of  the  underlying  securities  of  the  operating  companies 
themselves.  Later  the  extensions  were  paid  for  by  short-time  borrowings 
— notes  and  bank  loans — of  the  operating  companies.  During  1919  and 
1920,  even  this  expedient  failed,  and  the  holding  company  made  large 


438 


APPENDIX 


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PROBLEMS 


439 


Income  and  Expenditure  Account  Year  Ending  March 

31,  1921 


Branston 

Peabody 

Current 
River 

Conway 

Cartersboro 

Gross    Earnings    (Cus- 

tomers' receipts) 

Si03,7i6 

I567.31J 

142,716 

I49.133 

1611,442 

Operating  Expenses  (in- 

cluding taxes) 

69,816 

310.118 

41,102 

37.967 

318,961 

Dividends  on  Preferred 

Stock 

30,000 

Amount    of    Dividends 

paid      to      holding 

company- 

Cash 

30,000 

120,000 

Scrip 

30.000 

30.000 

Hamilton 

Albany 

Stoughton 

Carytown 

Gross    Earnings    (Cus- 

tomers' receipts) 

J209,007 

128,000 

$291,662 

I17.671 

Operating  expenses 

117,317 

21,000 

287,117 

21,718 

Dividends  on  Preferred 

Stock 

14,000 
(scrip) 

Amount  of  Dividends 

Cash 

Scrip 

20,000 

advances  to  6  of  the  operating  companies.  The  money  for  these  advances 
were  secured  by  three  methods :  (i)  ordinary,  unsecured  3  to  6  months' 
loans  from  its  banks,  regularly  renewed  at  each  maturity;  (2)  the  sale  in 
the  spring  of  1920  of  $1,000,000,  2-year  unsecured  8%  notes  to  investment 
bankers,  and  (3)  the  issue — followed  by  the  pledge — of  11,374,000  collat- 
eral trust  prior  lien  bonds.  The  collateral  trust  prior  lien  bonds  were 
used  to  secure  a  loan  of  $1,000,000  from  the  North  Avenue  National 
Bank  of  Chicago.  Subsequently  the  right  of  the  corporation  to  issue  this 
particular  block  of  bonds  became  subject  to  extended  litigation. 

The  following  represents  the  balance  sheet  of  the  Northern  Counties 
Light,  Heat  and  Power  Company  itself  as  of  March  i,  1921  (even  000): 


440 


APPENDIX 


Assets 

Securities  of  Operating 

Companies 

(Representing  the  en- 
tire common  stock 
issues  of  nine  electric 
light  and  power  com- 
panies) 

Collateral  Trust,  Prior 
Lien  Bonds  Pledged 
as  Collateral 

Demand  Notes  of  Oper- 
ating Companies 

Scrip  Dividends  of 
Operating  Companies 
1914  to  1920 

Bond  and  Note  Dis- 
count   

Miscellaneous  Assets.  . 

Cash 


7,941,000 


1,574,000 


2,337,000 


160,000 

110,000 

27,000 

4,000 

$12,153,000 


Liabilities 
Collateral  Trust  Prior 

Lien  5%  Bonds  Due 

March,  1941 

Notes     Payable     (less 

than  one  year) 

Two-Year    8%    Notes 

Due  April  i,  1922. . . 
North     Auburn     Nat. 

Bank  Loan 

Preferred  Stock 

Common  Stock 

Surplus 


4,574,000 

786,000 

1,000,000 

1,000,000 
1,500,000 
2,000,000 
1,293,000 


$12,153,000 


The  income  statement  for  the  year  ending  March  i,  1921,  was  as 
follows : 

Receipts  from  Dividends  of  Subsidiary  Companies $230,000 

Interest  on  Collateral  Prior  Lien  5's  September  i,  1920.. .     $150,000 
Interest  on  2-Year  Notes  Due  April  i,  1922 — October, 

1920 40,000 

Bank  Interest 49.817 

Salaries,  General  Expenses 38,791 

$278,608 

Deficit $  48,608 


The  collateral  trust,  prior  lien  bonds  had  been  sold  at  various  times 
from  1911  to  1915,  to  investors.  The  initial  offering  was  at  91^.  The 
preferred  stock  had  been  sold  originally  in  blocks  of  3  shares  of  preferred 
and  I  share  of  common  for  $250.  Of  the  $2,000,000  of  common  stock, 
approximately  $1,000,000  was  owned  by  Thomas  S.  Sargent  and  Company, 
but  pledged  with  a  New  York  bank  for  a  loan  of  $80,000.    Five  hundred 


PROBLEMS  441 

thousand  dollars  ($500,000)  of  the  common  was  owned  outright  by  the 
syndicate  which  originally  sold  the  blocks  of  common  and  preferred  stocks. 
This,  except  for  a  cash  commission  of  2%  on  the  gross  sales  to  customers, 
represented  their  entire  banking  profit. 

Prepare  an  exhaustive  report  covering  the  reorganization  of  the  com- 
pany. 

Chapter  XXVII — Reorganization  of  Industrials 

85.  Andrew  Stevens,  a  shoe  salesman,  and  Peter  Dobell ,  an  expert  fitting 
room  superintendent,  formed  a  partnership  in  Haverhill,  Massachusetts, 
in  191 1,  to  manufacture  ladies'  fancy  slippers.  They  were  backed  in  the 
beginning  by  Edward  Lawton,  a  capitalist,  who  had  married  Stevens' 
cousin.  He  loaned  $5,000  to  Stevens,  personally;  and  loaned  $20,000  to 
the  partnership  of  Stevens  and  Dobell.  Dobell  contributed  $5,000  of  his 
own  money.  At  the  end  of  191 1,  the  business  not  having  been  as  success- 
ful as  Stevens  had  painted,  Lawton  sought  to  withdraw  his  capital.  This 
created  ill  feeling  between  Lawton  and  Stevens,  resulting  finally  in  an 
agreement  between  the  two  under  which  Lawton  agreed  to  cancel  his 
personal  loan  of  $5,000  to  Stevens  and  his  loan  to  the  partnership  of 
$20,000  on  payment  of  $22,000  in  money.  Stevens  agreed.  He  secured 
the  co-operation  of  Thomas  Ingalls,  a  retired  shoe  manufacturer  of  Lynn, 
who  made  the  following  proposition:  The  Ingalls  Slipper  Company  was 
to  be  organized  with  $100,000  capital  stock.  Ingalls  would  settle  with 
Stevens  at  the  figure  mentioned,  and  pay  into  the  corporation  $25,000 
more.  Of  the  $100,000,  $10,000  par  value  was  to  go  to  Dobell,  $10,000  to 
Stevens,  and  the  remainder  to  Ingalls.  The  latter  was  to  become  president 
and  treasurer  of  the  company,  Stevens,  vice-president  and  sales  manager, 
and  Dobell,  factory  superintendent.    This  was  done. 

The  business  became,  almost  immediately,  very  successful.  The 
company  specialized  in  the  manufacture  of  a  simple,  cheap  slipper,  whole- 
saling for  about  40  cents  a  pair.  The  plan  was  to  make  a  small  profit  on  a 
large  turnover.  By  the  end  of  19 13  the  company,  by  the  reinvestment  of 
its  profits,  had  increased  its  net  worth  to  $165,000.  Meanwhile  the  com- 
pany had  piu-chased  a  factory  at  a  cost  of  $200,000,  the  lower  floors  of 
which  it  leased  to  tenants  and  carried  on  its  business  in  the  loft,  with  a 
shipping  room  in  the  basement.  Ten  thousand  dollars  only  had  been  paid 
down,  a  savings  bank  had  taken  a  first  mortgage  of  $100,000  on  the  build- 
ing and  the  remaining  payment  had  been  met  by  giving  the  company's 
i-year  note  for  $90,000,  secured  by  a  second  lien  mortgage  on  the  build- 
ing.   This  note  ran  one  year  from  August  i,  1913. 


442  APPENDIX 

During  the  spring  of  19 14  the  demand  for  slippers  from  jobbers  was 
excellent  and  the  business  was  as  profitable  as  in  the  previous  years.  The 
company  bought  only  enough  leather  and  materials  for  its  immediate 
needs,  so  that  a  minimum  of  capital  was  tied  up  in  its  inventories.  Its 
greatest  weakness  was  in  the  collection  of  its  accounts  receivable.  Owing 
to  the  large  volume  of  business  undertaken  by  the  company  and  relatively 
long  credits,  there  was  always  a  shortage  of  liquid  capital.  The  company 
had  received  liberal  accommodation  from  the  Haverhill  banlcs  and  had 
opened  a  $100,000  line  of  credit  with  the  Importers'  National  Bank  of  Bos- 
ton. This  required  an  average  deposit  of  $20,000.  It  had  been  the  inten- 
tion of  Ingalls,  the  treasurer,  gradually  to  transfer  his  entire  borrowings  to 
the  Boston  bank.  In  April,  1914,  owing  to  an  unfortunate  sale  to  a  Porto 
Rican  distributor  in  the  autumn  of  1913,  the  firm  found  itself  at  a  great 
loss  for  want  of  ready  capital.  Ingalls  did  not  dare  infringe  upon  his  cus- 
tomary deposit  of  $20,000  at  the  Importers'  National  in  view  of  his  pro- 
posed policy  of  increasing  his  loans  there.  He  could  not,  on  the  basis  of 
his  present  borrowings  in  the  Haverhill  banks,  reduce  his  deposits  there. 
As  a  last  resort  he  began  to  "sell"  his  accounts  receivable.  This  process 
consisted  in  borrowing  up  to  80%  of  the  par  value  of  certain  of  his  accounts. 
For  this  accommodation  the  Manufacturers'  Finance  Corporation  would 
charge  a  fee  or  fees  which,  in  the  aggregate  amounted  to  an  interest  rate 
of  nearly  14%  per  annum  on  the  actual  money  borrowed.  Meanwhile  it 
tied  up  the  accounts.  In  his  reports  to  the  Importers'  National  Bank  and 
to  the  local  banks  the  fact  that  specific  accounts  receivable  were  pledged 
to  the  Manufacturers'  Finance  Corporation  was  entirely  omitted,  although 
the  loans  themselves  were  included  under  bills  payable. 

The  indebtedness  on  the  accounts  receivable  tended  to  increase  during 
May  and  June,  due  largely  to  the  increasing  volimie  of  business.  Business 
was  unusually  brisk  during  July,  but  collections  were  slow.  Ingalls,  a 
narrow-minded  man  who  knew  little  outside  of  the  shoe  business,  was 
oblivious  to  the  foreign  situation.  The  seriousness  of  this  burst  suddenly 
into  his  consciousness  on  the  evening  of  July  25.  Conditions  were  con- 
spicuously unfavorable  for  him.  He  had  told  the  Merrimac  National  Bank 
the  day  before  that  he  intended  to  meet  a  note  of  $25,000  due  August  i, 
expecting  to  transfer  this  obligation  to  the  Importers'.  On  the  strength  of 
this  expectation  he  had  drawn  down  his  account  at  the  Merrimac  to  less 
than  $1,000.  To  make  matters  worse,  he  had  bought  a  lot  of  cut  soles, 
costing  $9,387,  at  a  special  price,  provided  he  should  pay  cash  for  them. 
The  soles  were  to  be  delivered  August  2. 

Now  fully  conscious  of  the  impending  crisis  in  world  finance,  he  called 


PROBLEMS 


443 


on  the  morning  of  July  27,  on  James  M.  Costigan,  the  president  of  the 
Importers'.  He  went  over  his  whole  situation  with  him.  The  interview 
was  cordial  and  friendly.  Costigan  promised  to  "take  care  of  him";  he 
promised  even  to  increase  his  aggregate  loans  to  $t:  50,000,  were  it  neces- 
sary, provided  the  current  condition  of  his  business  warranted  the  credit. 
Nothing  was  said  about  the  relations  with  the  Manufacturers'  Finance 
Corporation.    Ingalls  felt  reassured. 

Costigan  immediately  asked  a  special  Dun  report  on  the  Ingalls  Com- 
pany. It  reached  him  August  i ,  and  disclosed  the  account  with  the  Manu- 
facturers' Finance  Corporation.  He  immediately  telephoned  for  Ingalls 
to  come  to  Boston  for  a  conference.  The  latter  inferred  that  Costigan  was 
alarmed  over  the  sudden  burst  of  war  and  wished  to  ascertain  how  the 
Ingalls'  affairs  stood.  Instead,  he  was  asked,  in  very  direct  terms,  to  ex- 
plain his  relations  with  the  Manufacturers'  Finance  Corporation.  Ingalls 
hesitated  but  finally  admitted  that  he  had  specifically  pledged  certain  of 
his  amounts.  Costigan  then  told  him  to  close  his  account  with  the  bank 
within  10  days.  Three  days  later,  a  non-resident  creditor,  a  friend  of 
Ingalls,  petitioned  for  the  appointment  of  a  receiver.  Auditors  reported  as 
follows : 


Assets 

Building,  20  Merrimac  St.  $200,000 

Machinery  Owned 11 ,000 

Leather  and  Findings.  .  .  .  97,684 
Merchandise  Finished  and 

in  Process 27,719 

Accounts  Receivable 216,817 

Cash 26,741 


S579.961 


Liabilities 

Capital  Stock $100,000 

Mortgage  on  Building 100,000 

Second  Mortgage 90,000 

Manufacturers'  Finance 

Corporation 38,926 

Importers'  National 98,000 

Haverhill  Banks 17,000 

Merchandise  Debts 117,610 

Accrued  Interest  on  Mort- 
gage and  Note 2,794 

Surplus 15.631 

$579,961 


Auditors  reported  that  the  building  was  probably  worth  the  first  and 
second  mortgages,  but  would  probably  sell  for  no  more.  It  could  not  be 
sold  then  for  any  price.  The  machinery  had  a  second-hand  value  of  $4,300 
but  was  ample  and  sufficiently  modern  and  efficient  to  use  if  the  business 
was  continued.  The  leather  and  findings  had  a  current  value  of  about 
$42,000.    They  were  necessary  were  the  business  continued.    At  the  time, 


444  APPENDIX 

August  15,  1914,  there  was  little  demand  for  slippers  or  anything  else,  but 
the  finished  goods  could  probably  be  sold  directly  and  through  jobbers  for 
the  cost.  The  accotmts  receivable  represented  the  weak  point  of  the  busi- 
ness. At  least  $32,000  listed  were  valueless.  An  account  of  $61,000  with 
an  export  jobber,  on  account  of  a  jobber  in  Porto  Rico  was  probably  of 
little  value.  It  might  realize  10%  in  the  course  of  another  year.  $84,000  of 
the  accounts  were  certainly  good.  The  remainder  represented  small  sales 
directly  to  shoe  stores,  mostly  in  the  South  and  Southwest.  Their  value 
was  uncertain.  Little  could  be  realized  on  them  immediately  on  account 
of  the  war. 

The  liability  of  $38,926  to  the  Manufactiirers'  Finance  Corporation  was 
specifically  secured  by  $56,811  accounts.  Of  this  amount  $41,016  were  part 
of  the  $84,000  listed  as  certainly  good. 

The  receiver  was  asked  by  the  court  to  continue  the  business  tmtil 
January  i,  1915.  A  reorganization  plan  was  immediately  proposed  by 
Ingalls,  and  accepted  by  the  creditors. 

What  was  the  plan? 

**86.  The  Achilles  Tire  Company  was  organized  in  1914  by  James  An- 
derson, former  sales  manager,  for  the  eastern  district  of  the  Goodnow  Tire 
and  Rubber  Company,  who  contributed  $50,000  in  cash.  He  had  asso- 
ciated with  him  Heinrich  Meisel,  an  Austrian,  graduate  of  Bonn  University 
in  Chemistry,  who  had  devoted  himself  to  rubber.  Meisel  contributed 
$10,000.  Also,  Edward  Burr  Reznor,  a  native  of  Butler  County,  Pennsyl- 
vania, who  had  moved  up  to  Akron  in  the  early  days  of  the  rubber  indus- 
try and  had  made  a  fortune  from  his  holdings  in  the  old  Goodnow  Rubber 
Company  when  this  was  recapitalized  in  191 2  by  Wall  Street  interests, 
contributed  $435,000  in  cash. 

The  Achilles  Tire  Company  was  organized  with  $1,000,000,  7%  pre- 
ferred stock  and  $1,200,000  common  stock.  Anderson  took  $50,000  pre- 
ferred and  $250,000  common.  Meisel  took  $10,000  preferred  and  $100,000 
common.  Reznor  took  $435,000  preferred  and  $400,000  common.  The 
remainder  of  the  issues  were  placed  in  the  treasury  to  be  sold  later  as  the 
new  company  should  require  more  capital.  Before  the  organization  Ander- 
son signed  a  contract  to  act  as  president  and  general  manager  of  the  com- 
pany with  full  charge  of  the  purchase  of  materials  and  the  sales  of  the 
product.  He  was  to  receive  $1 2,000  a  year  for  a  period  of  5  years.  Meisel 
agreed  to  act  as  vice-president.  He  had  complete  charge  over  the  factory, 
including  every  detail  of  the  actual  manufacture  of  the  tires.  Reznor  was 
to  act  as  treasurer  with  only  nominal  duties.    He  was  to  receive  no  salary. 


PROBLEMS  445 

The  company  was  a  success  from  the  very  beginning.  Meisel  knew  the 
manufacturing  part  of  the  business  thoroughly.  He  loved  detail,  made  a 
most  painstaking  study  of  every  batch  of  tires  that  came  through,  invented 
a  new  testing  machine  to  discover  weak  points  in  the  fabric  and  an  alto- 
f;ether  new  device  to  prevent  buckling  while  the  tire  was  being  wrapped. 
Achilles  tires  soon  became  known  all  through  the  East  for  their  uniformity 
and  endurance. 

Meanwhile,  the  business  developed  into  a  great  financial  success.  In 
1916  the  company  sold  the  remainder  of  its  preferred  stock  to  the  public  at 
par.  Common  stock  to  the  amount  of  2,500  shares  was  sold  to  Akron 
brokers  in  1 9 1 7  for  $96  a  share.  Banking  connections  were  opened  with  the 
Warrentry  Trust  Company,  a  large  institution  in  New  York  which  insured 
a  reserve  credit  of  $500,000.  Schultz,  Eimer  and  Company,  note-brokers, 
opened  an  account  with  them  in  19 18,  and  by  the  end  of  the  year  had 
sold  over  $600,000  of  their  paper. 

The  gross  business  for  1919  was  twice  that  of  1918.  Anderson  arranged 
in  the  spring  of  1919  to  finance  the  Triton  mill  of  Summerville,  S.  C,  agree- 
ing to  take  its  entire  outfit  of  fabric.  The  Achilles  Tire  Company  acquired 
its  stock,  paying  $250,000  cash  and  $250,000  in  the  3-year  unsecured  notes 
of  the  Achilles  Tire  Company.  In  April,  1920,  Anderson  was  told  by  a  New 
York  broker  that  the  cotton  market  had  passed  beyond  control  and  prices 
for  long  staple  cotton  were  likely  to  double  by  October.  Spot  "contract " 
cotton  was  then  quoted  at  40  cents  a  pound.  Immediately  he  bought 
1,000,000  pounds  of  contract  cotton,  options  distributed  between  July, 
October,  and  December.  The  price  averaged  37  cents.  He  also  contracted 
for  500,000  pounds  1 1^  inch  staple  cotton  of  an  especially  fine  quality  with 
a  New  Orleans  factor  for  76  cents  a  pound.  In  May  he  entered  into  a  con- 
tract with  M.  Antigueoras  for  100,000  pounds  Egyptian  cotton  at  $1.05 
a  pound  delivered  at  the  fumigating  station  in  New  York.  Deliveries  to 
be  taken  at  the  sellers'  option  between  August  i  and  October  i.  He  pur- 
chased 1 ,000  tons  of  plantation  rubber  held  in  a  New  York  warehouse  and 
contracted  for  100  tons  a  month  with  an  exporting  house,  deliveries  to 
extend  from  June  i  to  January  i . 

While  Anderson  was  seeking  to  protect  himself  against  a  "runaway" 
market  for  raw  cotton  and  crude  rubber,  he  was  taxing  his  manufacturing 
capacity  to  the  utmost.  The  orders  had  been  running  far  ahead  even  of 
1919,  and  the  unfilled  orders  from  agents  and  dealers  were  increasing. 

Meisel  had  a  nervous  collapse  June  8,  as  a  result  of  overwork,  the  direct 
result  of  attempting  to  apply  detailed,  painstaking  efforts  to  large-scale 
production  without  having  built  up  a  capable  organization.    Almost  im- 


446  APPENDIX 

mediately  the  quality  of  the  tires  fell.  The  returns  of  blemished  tires  from 
dealers  were  twice  as  great  during  June  as  ever  before.  Three  car  loads  of 
tires  shipped  July  3,  to  a  large  New  York  wholesale  accessory  house  were 
rettimed,  on  the  claim  that  the  goods  were  not  equal  to  the  company's 
best  product,  on  the  high  quality  of  which  the  order  had  been  placed.  In 
accordance  with  the  firm's  custom  the  returns  were  accepted  without  ques- 
tion. Meanwhile  the  cancellations  of  orders  from  dealers  began  to  come  in 
in  an  alarming  manner.  Anderson  immediately  reduced  the  rate  of  output, 
so  that  for  the  first  2  weeks  of  July  the  shipments  of  tires  actually  accepted 
by  dealers  and  agents  were  about  equal  to  the  output  of  the  factory. 
Meisel's  chief  assistant,  who  had  assumed  charge  of  the  manufacturing  was 
doing  better  and  the  proportion  of  seconds  declined,  as  compared  with 
conditions  during  June.  July  15,  Anderson  covered  on  his  "spot"  unde- 
livered future  contracts  of  "contract"  cotton,  with  a  total  loss  of 
$61,000. 

On  July  29,  Meisel  evaded  his  attendant  and  leaped  from  a  third  story 
window  of  a  sanatorium.  He  never  regained  consciousness  and  died  the 
following  morning.  Reznor,  meanwhile,  had  been  carrying  automobile 
companies'  stocks  with  Lynch  and  Company  in  New  York  on  margin.  He 
lost  heavily  in  the  decline  in  the  Maxwell  shares  and  was  then  carrying 
10,000  shares  of  General  Motors  common,  purchased  during  the  autumn 
of  1919  between  $38  and  $41  a  share;  and  5,000  B.  F.  Goodrich  shares,  pur- 
chased the  year  before  at  prices  ranging  from  $74  to  $92  a  share.  In  addi- 
tion he  was  carrying  15,000  shares  of  other  stocks,  all  industrials  and  all 
showing  losses  from  the  purchase  prices.  August  9,  Lynch  telephoned  him 
for  more  margin.  He  pledged  everything  he  had,  even  his  Liberty  bonds, 
except  the  stock  in  the  Achilles  Tire  Company.  On  Sept.  15  Lynch  wired 
for  more  margin.  General  Motors  was  $20;  Goodrich  under  $60;  and 
nearly  all  the  remainder  of  the  securities  in  his  account  had  fallen  to  new 
low  levels.  Reznor  secured  a  loan  of  $300,000  from  the  Warrentry  Trust 
Company  of  New  York,  pledging  his  entire  holdings  in  the  Achilles  Tire 
Company  as  collateral.    This  entire  amount  was  handed  to  Lynch. 

The  entire  management  of  the  business  now  fell  on  Anderson,  as 
Reznor,  66  years  of  age,  was  incapable  of  making  any  decisions  in  the 
emergency. 

Anderson  closed  the  Triton  mill  on  September  13.  All  the  long  staple 
cotton  had  been  delivered,  but  none  of  the  Egyptian  cotton  bought  from 
Antigueoras.  About  half  of  the  long  staple  cotton  had  been  woven  into 
fabric  at  the  mill,  and  the  remainder  was  in  the  mill's  store  house.  He 
accepted  his  contracts  on  crude  rubber,  up  to  September  i,  and  obtained 


PROBLEMS 


447 


an  option  to  cancel  contracts  for  the  delivery  of  the  September  to  January 
crude  rubber,  provided  he  made  a  cash  payment,  on  or  before  October  i, 
to  the  exporting  house  of  $65,000.  He  reduced  the  tire  factory  to  half- 
time  on  September  3,  and  ceased  to  manufacture  on  September  20. 

Some  loans  at  the  local  Akron  banks  were  not  renewed  and  Anderson 
gradually  increased  his  loans  at  the  Warren  try  Trust  Company  until  they 
reached  $600,000,  a  hundred  thousand  dollars  more  than  the  credit  origin- 
ally arranged  for.  Schultz,  Eimer  and  Company  worked  loyally  for  the 
company  and  had  over  $1,000,000  of  notes  placed  among  their  cus- 
tomers. 

When  the  Warrentry  Trust  Company  heard  that  the  factory  was  closed 
they  wired  Anderson  and  Reznor  to  come  to  New  York  and  bring  a  full 
statement  of  the  condition  of  the  business.  Reznor  refused  to  go  and 
Anderson  went  alone.  He  explained  that  he  had  closed  the  factory  so  that 
he  might  have  an  opportunity  to  "work  off"  his  accumulated  stock  of 
goods.  He  stated  that  the  only  important  immediate  matter  that  would 
have  to  be  attended  to  was  the  Antigueoras  contract  which,  at  the  current 
market  for  Egyptian  cotton,  might  show  a  loss  of  about  $40,000.  He  said 
he  had  not  reduced  the  prices  of  his  tires  below  the  cost  of  production  and 
if  the  banks  would  extend  him  not  over  $100,000  credit  more,  at  the  most, 
he  could  liquidate  his  present  stock  of  tires  and  begin  to  manufacture 
again  the  raw  materials  he  then  held.  Even  if  the  wholesale  prices  of 
tires  were  reduced  materially  he  thought  that  these  raw  materials  could 
be  best  realized  upon  in  the  form  of  tires.  He  presented  the  following 
statement: 


Assets 

Tire  Plant,  Actual  Cost 

Less  Depreciation. . . .     $1,115,786 

Triton  Mill,  Cost 500,000 

Raw  Materials  De- 
livered and  Paid  for, 
or  in  Transit  and  Paid 
for,  Chiefly  Rubber 
and  Long  Staple  Cot- 
ton (Cost) 592,871 

Fabric,  Cost  of  Cotton 
Plus  Manufacturing 
Cost 296,021 

Tires,  Akron  Warehouse 
and  New  York  (Cost).  307,816 


Liabilities 

Capital  Stock 

Preferred $1,000,000 

Common  Issued  (Treas- 
ury $200,000) 1,000,000 

Schultz,  Eimer  and  Co. 

(Account) 1 ,090,000 

Triton  Mill  Notes 250,000 

Warrentry  Trust  Com- 
pany    600,000 

Akron  Banks 117,000 

Merchandise  Creditors. .  184,716 

Liability  Under  Cancel- 
lation of  Crude  Rub- 
ber Contract 65,000 


448 

APPENDIX 

Accounts  Receivable 

$ 

318,211 

Liability  Under  the  An- 

Notes of  the  Triton  Mill 

tigueoras  Contract. . . 

not    Represented    by 

Cotton  or  Fabric 

261,000 

Cash 

117,942 

Cotton  to  be  Received 

Under    Antigueoras 

Contract 

105,000 

Good- Will  Account 

750,000 

Stock  Discount  Account 

10,000 

Deficit 

37,069 

$4 

,411,716 

$105,000 


MII.7I6 


Anderson  reported  that  the  raw  materials,  inventoried  at  a  cost  of 
$592,871 ,  had  a  current  market  value,  based  on  spot  cotton  and  crude  plan- 
tation rubber,  New  York  delivery,  of  1218,700.  Fabric  mills  were  then 
quoting  fabric  prices,  immediate  delivery,  that  indicated  a  value  of  $119,- 
300  for  the  item  of  $296,021.  There  had  not  been  much  of  a  decline  in  the 
wholesale  prices  of  tires  but  the  "demand"  at  any  price  was  slight.  The 
accounts  were  probably  90%  good.  The  Triton  mill  was  one  of  the  best 
fabric  mills  for  its  size  in  the  south.  It  had  actually  cost,  with  the  im- 
proved machinery,  less  than  two  years  old,  about  $650,000.  It  owned  a 
valuable  water  power.  It  had  no  notes  or  other  liabilities  outstanding, 
other  than  its  notes  to  the  parent  company. 

A  few  hours  after  Anderson  had  submitted  this  report  to  the  Warrentry 
Trust  Company,  a  conference  was  held  attended  by  Anderson,  Aaron 
Eimer,  and  a  vice-president  of  the  trust  company.  Anderson  stated  his 
confidence  in  his  ability  to  work  the  situation  out,  and  offered  to  surrender 
his  stock  to  a  committee  of  bankers  to  protect  the  company's  creditors. 
This  plan  was  acceptable  to  the  vice-president  of  the  Warrentry  Trust 
Company,  who  offered  to  provide  a  further  credit  of  $50,000,  provided 
Schultz,  Eimer  and  Company  would  guarantee  an  equivalent  credit  if 
$100,000  was  required  before  Anderson  could  liquidate  on  his  inventories. 
Eimer  flatly  refused,  claiming  Reznor  had  deceived  him  in  stating  the 
company's  liabilities  as  he  had  said  nothing  concerning  the  future  contracts 
in  rubber  and  cotton.  He  demanded  an  immediate  receivership  and  the 
complete  elimination  of  Anderson  and  Reznor.  Reluctantly  the  Warren- 
try Trust  Company  consented,  and  3  days  later  a  local  Akron  lawyer  was 
appointed  receiver  under  a  non-resident  creditor's  bill. 

Why  was  the  Warrentry  Trust  Company  opposed  to  a  receivership  and 
Schultz,  Eimer  and  Company  in  favor  of  it? 


PROBLEMS  449 

Granting  Anderson's  statements  of  his  situation  were  correct,  prepare  a 
balance  sheet  such  as  auditors  for  the  receiver  might  present  to  a  creditors' 
committee. 

Prepare  a  plan  of  reorganization  for  the  Achilles  Tire  Company.    (The 
experience  of  this  tire  company  should  be  compared  with  that  of  the  Mayer 
Manufacturing  Company.    See  problem  54,  page  391.) 
29 


INDEX 


Accounting, 

auxiLary  company.  141 

confidence  in,  171 

importance  of,  122 

intercompany,  141 

need  of,  122 

proprietary  company,  141 
Adjustments    Required    in    Computing 

Net  Earnings,  127 
Agricultural  Associations,  255 
Amortization  of  Bond  Discount,    144 
Assessments, 

creditors,  339 

industrial  reorganization,  337 

railroad  reorganization,  315 

security-holders,  337 
Associations, 

agricultural,  255 

certificate  of,  13 

district,  253 

manufacturers,  256 

shares  in,  11 
Assumed  Bonds,  27 

Auditors,  Investigation   for  Reorgan- 
ization Committee,  308 
Auxiliary  Company,  Accounting,  141 


Balance  Sheet, 

comparative,  124 

defined,  123 
Balanced  Returns, 

illustrations,  195 

law  of,  described,  193 
Banker, 

commissions,  lOS 

fictitious,  s6 

judgment  of  promotion,  47 

organization  of  distributing,  69 

point  of  view,  44 

profit  of,  at  promotion,  68 

service  of,  74 

work  of,  at  promotion,  46 


Bonds, 

assumed,  27 
bridge,  22 
car  trust,  26 
classification  of,  20 
collateral  trust,  25 
component  parts  of.  18 
consolidated  mortgage,  23 
convertible,  33 
debenture,  28 
denomination  of,  31 
different  from  stock,  8 
discount,  144 
dividends,  180 
divisional,  22 
dock,  22 

earnings  as  security  of,  30 
equipment  trust,  26 
example  of,  18 
first  mortgage.  21 
general  mortgage,  23 
guaranteed,  28 
income,  28 
interest  rate  of.  31 
joint,  28 
junior,  22 
maturity  of,  31 
mortgage.  21 
open  mortgage,  30 
preferred  stock,  protection  from,  42 
priority  of,  22 
property  security  of,  21 
public  utility,  100 
railroad,  84 
real  estate,  22 
receiver's  certificates,  27 
redeemable,  33 
refunding  mortgage,  24 
sale  of  for  expansion,  269 
salesmen,  70 
second  mortgage,  22 
security  of,  21 
serial,  149 
terminal,  22 
warehouse,  22 
wharf,  22 
wording  of,  18 
Bridge  Bonds,  za 


451 


452 


INDEX 


Car  Trust  Bonds,  26 
Causes  of  Failure,  289 
Chain  Store,  Economies  of,  21s 
Collateral  Trust  Bonds, 

description  of,  25 

railroad  consolidation,  23s 
Combinations  (See  "Industrial    Combina- 
tions," "Railroads,  consolidations") 
Committees, 

investigation,  308 

reorganization,  303 
Common  Stock  (See  "Stock") 
Community  of  Interests, 

associations,  253 

evolution  of,  248 

form  of,  247 

integrated  industries,  258 
Competition, 

among  industrials,  225 

among  railroads,  225 

cause  of  combination,  20S 

failure,  caused  by,  290 
Consolidated  Mortgage  Bonds,  23 
Consolidation, 

collateral  trust  bond,  235 

exchange  of  stock,  234 

industrial     (See     "Industrial     Combina- 
tions") 

large,  226 

railroads  (See  ' '  Railroad ,  consolidations  ") 
Construction  Company, 

abuses  of,  82 

examples  of,  78 

historical  cases  of,  78 

operation  of,  79 

profits  of,  81 
Contingent  Rentals,  229 
Convertible  Bonds,  33 
Corporation, 

development,  i 

financial  structure,  I 

limited  liability  of,  4 

origin,  i 

personal  liability  in,  3 

wide  distribution  of  investments  in,  S 
Corporation  Finance, 

description  of,  I 

scope  of,  6 
Cost   of    Property    in    Public    Utility 

Promotion,  91 
Credit,  Bonds  Secured  By,  27 
Creditors,   in    Industrial    Reorganiza- 
tion, 

assessment  of,  339 


Creditors,    in    Industrial    Reorganiza' 

TiON — Continued 
position  of,  331 
Cumulative    Dividends,   on   Preferred 

Stocks, 38 
Customers'  Lists  for  Investments,  71 
Cycle  of  Industrial  Combinations,  201 


Dead  Reckoning  of  Earnings,  6s 

Debenture  Bonds,  28 

Deficit,  Defined,  126 

Demand,    Cessation    of,    as    Cause    of 

Failure, 296 
Denomination  of  Bonds,  31 
Depreciation  Defined,  131 
Diminishing  Returns,  189 
Discounts, 

bond, 144 

treatment  of,  138 
Distributing  Bankers  (See  "  Bankers  ") 
District  Associations,  253 
Dividends, 

bond,  180 

cumulative,  38 

effect  of  industrial  reorganization  on,  341 

extra,  180 

on  preferred,  39 

payment  of,  as  a  cause  of  failure,  296 

policy  of,  167,  184 

preferred  stock,  36,  38,  39 

principles  underlying  declaration  of,  167 

property.  181 

rates  of  preferred,  36,  37,  38 

regularity  of,  174 

scrip,  180 

stock,  181 

taxation,  181 
Dock  Bonds,  22 


Earnings, 

as  basis  of  security,  30 
dead  reckoning  of,  65 
estimate  of, 

dividend-paying  company,  176 

established  industry,  63 

public  utility,  91 
fluctuations  of,  179 

among  industrials,  336 
investment  of,  for  expansion,  264 
law  of  regularity  of,  179 
net,  computing,  127 
prediction  of,  176 
previous,  as  affecting  estimates  ,  96 


INDEX 


453 


Earnings — Continued 

stock  issued  against,  67 

test  oi,  among  public  utilities,  93 
Electric  Railway,  Promotion  of,  87 
Equipment  Trust  Bonds,  26 
Estimates, 

for  dividend  policy,  176 

of  earnings,  63 

public  utility,  92.  96 
Expansion    (See    also    "Industrial    Com- 
binations") 

big,  ami  little  businesses,  200 

failure,  caused  by,  290 

law  governing,  193 

manufacturing  industries,  292 

motives  leading  to,  187 

of  business,  186 

public  utility,  292 

railroads,  221,  226,  293.  3i3 

unbridled, 

economic  laws  behind,  211 
failure  of,  211 
Extra  Dividends,  180 


Failure, 

causes  of,  289,  303 

events  preceding,  303 

first  class,  320 

primary,  320 

railroads,  cause  of,  313 

second  class,  321 

secondary,  321 

small  railroads,  322 

third  class,  322 
Fam'ly  Group  of  Industries,  261 
Financial  Plan, 

established  industry,  63 

ir.tenirbar  electric  railroad,  87 

promotion,  49 

public  utilities,  99 

railroads,  76 
Fixed  Property, 

distinguished  from  self-liquidating,  266 

financing,  268 
Fixed  Rentals,  230 
Foreign  Trade, 

combinations, 
reasons  for,  216 
types  of,  217 

community  of  interests  in,  260 
Franchise,  Public  Utility,  90 


General  Electric  "Family,"  261 
General  Mortgage  Bonds,  23 


Gentlemen's  Agreements.  249 
Guaranteed  Bonds,  28 

H 

Holding    Company    (See    "Public    Utility 
Holding  Company  ") 


I 


Income  Account.  Defined,  123 
Income  Bonds,  28 
Incorporation,  Articles  of,  4 
Industrial  Activity,  Effect  on  Public 

Utility  Earnings,  93 
Industrial  Combinations, 
advantages,  20s 
cessation  of,  reasons  for,  203 
chain  stores,  215 
exporters,  217 
failure  of,  206,  211 
foreign  trade,  216 
historical  survey,  200 
integrated  industries,  214 
manufacturers  engaged  in  foreign  trade, 

218 
presumption  of,  20s 
reasons  for,  205 
recent,  204 

successful  types  of,  214 
Webb  Act,  219 
Industrial  Corporations  (See  also  "In- 
dustrial Combinations") 
expansion  of,  186,  200 
failure  of,  289 
preferred  stocks  of,  36 
reorganization      (See      "Industrial      Re- 
organizations") 
Industrial  Reorganizations, 
assessments  in,  337 
contrasted  with  railroad,  330 
effect  on, 
debt.  341 

dividend  charges,  341 

interest  charges,  343 

money  requirements,  33S 

personal  element  in,  333 

purpose  of,  334 

Insurance, 

investment  of  reserves,  162 
reserves,  160 
self,  160 
Integration, 

community  of  interests  in,  258 
reasons  for,  214 
successes  in,  214 


454 


INDEX 


Intercompany  Accounts,  141 
Interest, 

charge  of,  in  accounting,  138 

on  funded  debt,  140 

reduction  of, 

in  industrial  reorganizations,  343 
in  railroad  reorganizations,  314.  328 
Interest  Rate  of  Bonds,  31 
Interurban  Electric  Railway,  87 
Invention^,  Promotion  of.  52,  53 
Inventor,  Relation  to  Promoter,  52 
Inventories,    Depreciation   of.    Effect 

on  Preferred  Stocks,  41 
Investigation  Committee,  308 
Investments, 

matters  of  fashion ,  65 

of  earnings,  264 

of  surplus,  15s 

prejudices,  65 

promotion,  time  of,  44,  45 

weakness  of  preferred  stocks,  39 

wide  distribution  in  corporations,  S 
Investor  (See  also  "Investments") 

vanity  of,  59 


Joint  Bonds,  28 
Junior  Bonds,  22 


Land  Grants,  to  Railroads,  76 
Liability, 

limited,  in  corporation,  4 
personal,  in  corporation,  3 
Lien, 

of  bonds,  21 

of  preferred  stocks,  35 


M 


Management,  Importance  of  in  Indus- 
trials, 64,  334 

Manufacturers'  Associations,  256 

Manufacturing  Businesses  (See  "Indus- 
trial Corporations") 

Massachusetts  Trusts,  12 

Maturity  of  Bonds,  31 

Moral  Temper  of  Community  as  it 
Affects  Public  Utility  Earnings,  95 


N 


Net  Profits,  Computation  of,  127 
No-Par-Value  Stock,  14 


Notes,  Short-Teem, 
for  expansion,  265 
public  utility,  loi 


Obsolescence  Defined,  133 
Open- Mortgage  Bonds,  30 


Par  Value  of  Stock,  14 

Plan,  Financial  (See  "Financial  Plan") 

Plans,  Reorganization,  309 

railroad,  318 
Pools, 

description  of,  251 
types  of,  251 
Population,      as      Affecting      Public 

UTiLrTY  Earnings,  93 
Preferred  S-tocks, 
assets  lien  on,  35 
dividends  on,  36,  38,  39 
cumulative,  38 
extra,  39 
increased,  39 
provisions  for,  36 
efifect    of    depreciated    inventories    on, 

41 
issues  of,  38 
lien  of,  35 
origin,  34 
protection  from   note,   bond,  and   stocic 

issues,  42 
public  service,  37 
public  utility,  loi 
railroad,  38 
rates  for  industrial,  36 
sale  of,  for  expansion,  278 
voting  rights  of,  43 
weakness  of,  39 
Priority  of  Mortgage,  22 
Privilege, 

definition  of,  283 
formulas  for,  284 
requirements  of,  270 
subscription  of  stock,  377 
terms  of,  283 
underwriting  of,  286 
value  of,  284 
Profits,  Computation  of,  127 
Promoter  (See  also  "Promotions") 
functions  of,  45 
inventor's  relation  to,  52 


INDEX 


455 


Promoter — Continued 

lighting  company,  91 

personality  of,  45 

point  of  view  of,  44,  46 

profit  of,  68 

types  of,  45 
Promotions,  44,  51  (See  also  "Promoter") 

electric  railway,  87 

established  industry,  62 

human  factors,  104 

investor's  attitude  toward,  45 

public  utilities,  90 

railway,  76 

stages  of,  SI 
Property, 

cost  of  in  public  utility  promotions,  91 

dividend  in,  i8r 
Proprietary  Accounts,  141 
Prospectus  of  Public  Utility,  90 
Public  Aid  to  Railroads,  76 
Public    Service    Commission,  Attitude 
of  Toward  Value  of  Public  Utili- 
ties, 98 
Public  Service  Companies, 

economic  stability,  98 

estimated  savings  of,  92,  96 

financial  plan,  99 

preferred  stocks  of,  37 

promotion  of,  90 

value  of,  97 
Public  Utility  Holding  Company 

advantages  of,  240 

description  of,  239 

financing  of,  242 

forms  of,  246 


Railroad  Reorganization, 

assessments,  315 
contrasted  with  industrial,  330 
first-class,  322 
plan,  318 
primary,  322 
purposes,  314 

reduction  of  fixed  charges,  314 
secondary,  326 
second-class,  326 
small  railways,  328 
theory  of,  313 
third  class,  328 
Railroads, 
bonds  of,  84 

collateral  trust  bonds,  23s 
combination,  221 
consolidation,  221 
end-to-end,  223 


Railroads — Continued 

consolidation — Continued 
merger,  232 
methods,  229 
of  systems,  226 
periods  of,  222 
stock  purchase,  232 

construction  company,  78 

description  of  promotion,  8S 

early  history  of,  76 

electric  railway  promotion,  87 

expansion,  221 

failures  of,  313 

financial  plan  of,  76 

land  grants,  76 

preferred  stocks  of,  38 

primary  failure  of,  320 

prominence  of  bonds,  84 

promotion  of,  76,  78 

public  aid  to,  76 

rentals,  229 

reorganization  (Sec  "Railroad   Reorgani- 
zation") 

secondary  failure  of,  321 

small,  failure  of,  322 

systems,  formation  of,  224 
Real  Estate  Bonds,  22 
Receivers'  Certificates,  27 
Redeemable  Bonds,  33 
Refunding  Mortgage  Bonds,  24 
Rentals, 

accounting  of,  143 

contingent,  229 

fixed,  230 

railroad,  229 
Repairs,  Defined,  130 
Reorganization, 

assessments, 
creditors,  339 
of  security-holders,  337 

committees,  303 

dividend  charges,  effect  of,  341 

effect  on  capitalization,  328 

factors  involved,  299 

first-class.  322 

importance  of,  288,  300 

industrial    (See   "Industrial   Reorganiza' 
tions") 

interest  charges,  effect  of,  328,  343 

legal  procedure,  30S 

methods  discussed,  299 

motives  governing,  302 

new  money,  315 

plans, 

execution,  31 1 
formation  of,  309 


456 


INDEX 


Reorganization — Continued 

procedure,  legal,  305 

railroad  (See  "Railroad  Reorganization") 

reduction,  fixed  charges,  314 

voluntary,  34s 
Reserves, 

classification  of,  158 

depreciation,  159 

insurance,  160 

investment  of    162 

necessity  of,  1S7 

tax,  159 

uncertainties,  i6s 

unremunerative  improvements,  164 
Returns,  Law  of  Balanced, 

described,  193 

illustration  of,  19S 
Rights  (See  also  "Privilege") 

definition  of,  284 

formula  for  computing  values,  284. 

market  value,  284 

value  of,  284 
Royalties,  143 


s 


Salfsmen, 

meetings  for,  72 

training  of,  70 
Scrip  Dividends,  180 
Second  Mortgage  Bonds,  22 
Self-Liquidating  Property, 

description,  266 

financing  of,  267 
Senior   Bonds    Different   from   Junior 

Bonds,  22 
Serial  Bonds,  149 
Sinking  Funds, 

accounting  of ,  14s 

historical  significance,  147 

investment  of,  147 

occurrence,  146 

reason  for,  146 
Speculative  Instinct,  58 
Speculative  Securities, 

appeals  of,  57 

how  sold,  61 

sale  of,  55 
bTOCK  (See  also  "Preferred  Stocks") 

certificate,  10 

control  by  railroads,  233 

difference  from  bonds,  8 

dividends,  181 

early  use  of,  7 

earnings  issued  against  by  public  utilities, 
102 


Stock — Continued 

full-paid,  IS 

industrials,  67 

par  value  of,  14 

privileged  subscription,  277 

prospective  profit  issued  against,  66 

public  utility,  102 

purchase  by  railroads,  232 

railroads,  84 

sale  of, 

by  corporation,  55 
for  expansion,  270 

significance  of, 

types,  9 

voting  power  of,  16 
Sucker  Lists,  60 
Surplus, 

defined,  126 

earnings,  150 

investment  of,  155,  169 

misrepresentation,  avoidance  of,  167 

paid-in,  150 

premium,  152 

sale  of  book  assets,  153 

sources,  150 

stockholders,  167 

use  of,  167 
Syndicate  Underwriting, 

description  of  in  detail,  no 

history,  in 

loans  on,  120 

participation  in,  116 

risks  of,  III 

selling,  116 

simplest,  112 

types  of,  112 

unsuccessful,  114 


Taxation  of  Stock  Dividends,  181 

Terminal  Bonds,  22 

Trusts    (See    also    "Industrial    Combina- 
tions") 

collateral  trust  bonds,  25 

equipment  trust  bonds,  26 

Massachusetts,  12 

voting,  16 
Turnover,  Relative  Rate  of,  170 


u 


Underwriting  Syndicate  (See  "Syndicate 
Underwriting") 


INDEX  457 

V  w 

Voluntary  Reorganizations,  34s  Warehouse  Bonds,  22 

Voting  Rights  of  Stock,  16  Wealth   of   Community,   as   it  Affects 

preferred,  43  Public  Utility  Earnings,  93 

Voting  Trusts,  16  Webb  Act,  219 

Wharf  Bonds,  22 


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